HAS U.S. RESIDENTIAL REAL ESTATE BOTTOMED? YOU HAVE TO BE KIDDING! (January 29, 2007): In recent weeks, there has been a lot of talk in the media about how U.S. residential real estate may have bottomed. This makes about as much sense as saying in 2000 that the Nasdaq, which peaked at 5132.50, had bottomed once it fell all the way to 5000. According to Professor Robert Shiller of Yale University, the average price of a house in the U.S. was virtually constant in inflation-adjusted terms from 1890 through 1997, but by the beginning of 2006, had risen to 199% of its 1890 level. In other words, after being nearly constant for more than a century, real estate suddenly surged to twice this level in real terms.
If something which has been at a particular valuation for over a century suddenly doubles, then one should be instinctively suspicious. More importantly, it is absurd to think that a 4% or 5% decline from such a level represents anything close to fair value. Of course, nothing moves in a straight line; that is how the financial markets have always worked. But one must remember why real estate became so overvalued in the first place. The Federal Reserve intentionally engineered the real-estate bubble in order to counteract the negative effect of the collapse of the Nasdaq's bubble--a euphoria which the Federal Reserve had also created, although that's a story which I (and many others) had already told years ago.
Banks and mortgage companies changed their entire way of doing business. For centuries, they would determine a potential buyer's income and assets, and say to that buyer: here's your income, here's your assets, this is what we think you can afford, so you can buy anything up to this amount but not any more--typically twice the total annual household income. The down payment would average about 25%.
Beginning several years ago, bankers had a new approach; they would say: okay, here's your income, here's your salary, now don't let those numbers worry you, just buy whatever house you always dreamed you could own, however expensive it may be, and we'll tailor our loan to fit your needs. If you can afford a traditional mortgage, fine--we hardly see folks like that anymore. If you can't afford a traditional mortgage, then we'll make you an interest-only mortgage. And if you can't afford an interest-only mortgage, don't fret, because we'll make you a negative-amortization mortgage. Sure, your mortgage balance will rise every month, instead of falling, but, hey, times have changed. You don't drive your father's Buick, so why get your father's kind of mortgage where you actually pay off the loan eventually? That's terribly old-fashioned. And, by the way, we expect that you won't be able to afford any down payment, which is fine, because no one makes those nowadays. In fact, we don't even ask for one.
There's a saying among poker players that if you sit down at a table and can't tell after a few minutes who the "patsy" is--that means the player who doesn't know what is going on and is about to go broke--then you're the patsy. If you're a banker or a mortgage broker and you lend money to a house buyer who cannot make the mortgage payments and defaults on the loan, then you have to foreclose. If you've given that buyer a negative-amortization loan on a $700,000 house, and meanwhile the mortgage balance is now $800,000 while the house price has fallen to $650,000, and you have no down payment from that buyer, then it's not the buyer who will suffer, except for his or her credit rating. It's you--the banker--who's the patsy! Because now you have a $150,000 loss, even assuming that you can sell the house immediately, which is not so easy these days. Once investors wake up to this reality, they will force the boards of these banks and mortgage companies to make future loans much more difficult to obtain. Congress may even outlaw negative-amortization loans, as occurred in Japan during their 64% collapse in real-estate prices. The immediate impact of tightened standards will be fewer buyers that qualify to purchase any given house, which will further depress housing prices. It's not going to be a pretty picture, and prices are not going to bottom anytime soon.
In Japan, residential housing prices declined for fifteen consecutive years, from 1990 through 2004. That's not a misprint or an exaggeration. In Japan, where one brings shame upon one's entire family for defaulting on a mortgage, there was no panic in the market, just a continuous decline. In the U.S., where defaulting will become a nationwide pastime in the next decade, there will likely be a much more rapid and chaotic situation, which will likely take quite a bit less than fifteen years, but which could be equally devastating.
So until you see banks demanding a 25% down payment and offering only traditional mortgages, you can be sure that the housing market is far from bottoming. In other words, once mortgage standards return to their 1999 levels, so will housing prices return to their 1999 levels.
ASX Price at posting:
0.0¢ Sentiment: Buy Disclosure: Not Held
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