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From the Comments: Why So bearish on Housing, TC?

January 12, 2011

TC is Bearish the Housing Market

In the comments on my Strategic Analysis Page, someone asked why I was so bearish on Housing.

I have a list of reasons:

1. Dr. Housing bubbles rental posts: Seems like much of California is still 100% overpriced compared to rentals.  Many parts of California still have significant drops coming.
2. Long term Housing prices from Robert Schiller shows that the depression shaved 50% off home prices. A similar bust today would take us down 20% more.
3. Foreclosed properties are trading at a 25% discount right now.
4. We have a huge shadow inventory of homes sitting out there, either not foreclosed or foreclosed and not on the market.
5. We’re looking at 9% unemployment for the next 3 years, even with a moderate recovery.  This is an extra 5% of people who wont even consider purchasing a house.
6. 22-25% of the housing market is  “underwater”, so I expect strategic defaults to increase starting Q3 2011. I’ve had 2 people ask me for advice about how to “give the house back to the bank” in the last 3 months, planning for next year. Mike Konzal is right to point out this hasn’t happened yet, and that you paid more money for the right to do this.  He is wrong to think that because it hasn’t happened, so it won’t happen.  This is a meme that is slowly finding its way into the popular consciousness.*

7. Standard market price overshooting during bad and good times
8. Securitization process broken, so home loans are more difficult to get today
9. Expectations that prices will be lower delays purchases.

All of this adds up to a 20% drop easily, with significant risk of further downside to a 30% drop. I do not have a formal data model to support this contention.  Housing prices seemed to jump after the War to a new level. Is this the correct level, or is the pre-war level more appropriate?

*About the Mike Konzal post, I found this section very interesting.  (P.S. That guy is on fire – he just keeps writing excellent posts.)

“You can see this in the testimony of David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at a House committee:  ”In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.”  So what you see is a lot of people, over half, who have stopped paying their first mortgage trying to make some sort of payment.   If people were economically informed, financially literate and strategic they’d not pay the second (especially if they can’t pay the first).   But they want to be paying something.”

Mike takes this as good news – that we have people paying their second when they should be paying their first, and are financially illiterate.  And it is in a way.

But I take this same information very differently.  These people who are paying their first and not the second are strategically defaulting.  They know that every ding on their credit makes a difference.  If I am not mistaken, the second mortgage is a recourse loan – and banks are likely to go after them for a judgement or check garnishment if they do not pay.  This can happen extremely rapidly.

These homeowners would have to go into bankruptcy to write it down the second.  However, if the house is repossessed, the second may get wiped out in the process.  It is worth speculating on this in todays market.

[Updated by adding Link.  I am still getting the hang of this!]

  1. Peter D
    January 13, 2011 at 8:29 pm

    These are all valid points, thanks. I am not sure second liens are recourse in all jurisdictions – our servicing team weren’t too clear on that either (it’s amazing how many rules and regulations there are about these things that even professionals find hard to navigate), but in many it looks like they are, especially in the biggest states like CA. I am sure there are some savvy borrowers that might strategically default, but I would guess a lot don’t know such intricate details. As one person at our servicing dept suggested, a lot of folks might be just paying the lower of the bills thinking this will somehow keep them in the house. I dunno.
    But, in general, don’t you think that a huge drop like this – 20% to 30% – will increase the risk (to put it mildly) of a double deep for the US economy?

    • TC
      January 16, 2011 at 12:07 pm

      I too have been surprised at the difficulty of finding out the status of recourse on seconds in various jurisdictions. Even the status of firsts is not entirely clear – it appears the lenders have choices that could result in recourse on firsts in some states that are considered to be non-recourse.

      I thought that someone out there would have gone through, and done the research.

      It very well may be that these people are paying their second on the mistaken belief that this will keep them in their home. I’ve always found that people get surprisingly sophisticated on their personal finances when they need to. So I just gave them the benefit of the doubt of a bit of intelligence, so it looks to me like they are actually strategically defaulting.

      This would also explain the response from bigwigs that Konzal points out – where they are talking about current strategic defaults as a ongoing and growing problem. They are worried about it because it looks to them like thats what people are doing.

      I know of a few funds that are focusing on specific states for foreclosure restructuring. They are working with individual foreclosures, buying the property and restructuring the payments with the current occupants. If you had a good servicing infrastructure this could be very lucrative. Identify people that are likely to pay, then buy those foresclosures at 50% less than current prices, then restructure the loan at 30% less than current prices.

      On the apparent mismatch between real estate going down 20% more and an economic recovery – good point! Not many people catch this one, or think that I am crazy for even thinking this so do not bother.

      But I broke down the effects of the 20% fall in prices into two different broad categories, and it became clear to me that there would likely be little effeect on the economy. My categories were: Real economy and Financial Economy and then I looked for any cross-effects. It looks to me like all of the real economy shocks happened with the first leg down, and there will be little additional real world impact on spending from a further decrease in housing prices.

      I will write a post on this, but here is basic outline of my thinking.

      Real Economy:
      No additional job losses in construction and housing related employment. This sector is at minimum employment now.
      Consumer Spending from refis: no impact – this market is dead, shock has already happened
      Consumer Spending from Wealth Effect: small negative impact, shock has already happened
      Aggregate Demand from Steve Keens Credit Impluse: no more negative impact, lending has contracted by maximum already.

      Financial Economy
      No decrease in lending to buy homes. Home lending has already been effectively nationalized, so lending criteria will not change
      No impact on liquidity. Repo industry has been nationalized. Where people formerly used the repo market to squeeze a few bps out of extra cash or securities, they are using the Fed payment on reserves as a way to get these extra bps. The liquidity shock already happened with Lehman, and the world financial system no longer relies on repos for liquidity – it relies on the Fed.
      Little fallout from the bank nationalization Further declines in housing will make it clear they are broke, so there will be a nationalization. Nationalization will happen more along swedish lines, where shareholders are wiped out, bondholders are written down. My question is anyone out there looking at the current values of bank bonds as the real values besides the banks? I would say no.
      Fall in value of RMBS: has an impact on pension funds as these have more forced writedowns. I Look for a bailout of pension plans in 2013-2014 time frame. But all of this is just replacing money that was in the real estate market with new government money. It is a spreadsheet calculation, getting a number from B245 instead of A3. It will cause terror (or giddy elation) in the hearts of BVs, but won’t make a difference to the real world other than to make pension plans solvent where they are not solvent now based on realistic real estate values.

      So when I look at how the fall in real estate values further impacts the real economy and specifically aggregate demand, I do not see much of an impact. No new demand destruction, an already retrenched consumer, little credit creation from the big banks, and no will to nationalize the banks. From the financial side, because the bad news has already shut down the entire real estate financial channel, additional bad news won’t have much negative impact.

  1. August 3, 2011 at 1:45 pm
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