This week I am in New Orleans at the annual New Orleans Investment Conference and quite frankly with so many good friends that I have given myself permission to not write a letter this week. But you will be getting an even better writer than me for this week's letter.
I arranged for good friend Gary Shilling to condense his 40 page letter on the housing market for you. While this letter will print long (for those of you who print the letter out), it is mostly charts, which Gary excels in. Gary argues that housing prices are not in for just a small decline but a material drop. I have argued that it is housing that will be one of the main causes of the next recession sometime next year. So without adding too much more copy, let's jump right into Gary's analysis. If you like this type of work, you can subscribe at http://www.agaryshilling.com/insight.html.
By Gary Shilling
I am convinced that the housing bubble is gigantic and will burst before long with massive implications here and abroad. In fact, it's the key to the global economic outlook.
Setting the Scene
House prices in recent years have leaped well beyond their normal relationships to the CPI.
Even when the increasing size of houses--the McMansion effect--is excluded, inflation-adjusted house prices have jumped as never before in over a century.
Furthermore, for the first time since the 1920s, the bubble is nationwide, and it's been driven by four national forces. First, the decline in mortgage rates.
Second, the loose lending practices designed to accommodate those who have been priced out of the market under conventional mortgage terms.
We're referring here to interest-only Adjustable Rate Mortgages as well as option ARMs that allow borrowers to make even lower monthly payments that result in a rising mortgage principle, or "negative amortization." Then there are unrealistically high property appraisals to justify oversized loans and the lack of full documentation that allows borrowers to overstate their ability to make mortgage payments. Lenders also accommodate financially-weak borrowers with high loan-to-value ratio and piggyback loans, which in effect finance more than 100% of the houses' prices.
The Grand Disconnect
These loose lending practices are a manifestation of the massive speculation that infected stocks in the late 1990s and was never eliminated, despite their 2000-2002 collapse. Substantial ease by the Fed and other central banks, aided and abetted by big tax rebates and cuts and U.S. government spending on homeland security and military needs, kept the 2001 recession short and speculation intact. It simply shifted from dot com stocks to private equity, commodities, emerging market stocks and bonds, hedge funds and, especially, real estate as investors remained convinced that they deserved 20% returns each and every year. If U.S. stocks didn't do the job, surely other investments would.
So, gigantic levels of speculation remain. But they won't be eliminated and the yawning Grand Disconnect between the real world of goods and services and the financial world of asset speculation won't disappear unless forced by significant events. Speculations never end voluntarily or in orderly fashions. Meanwhile, the game continues for five reasons.
Reason A, the world has been awash in liquidity, which amply feeds speculation. It comes from the leap in house values, which have been liquefied by refinancings and home equity loans.
Reason B, speculation feeds on itself, as was seen with the dot com bubble and, more recently, in gold and emerging market stocks. There's nothing like making money to insure speculators that their bets are correct and should be redoubled.
Reason C, institutional and other investors yearn for huge returns. Their clients demand them. Many pension funds still have 9% or so expected returns. And money managers that don't produce consistent high gains lose money to those who do. So there's great willingness to take sizable risks.
Reason D, a perceived risk, at least until recently, has been low. With roaring profits, junk bond default rates remain low. The low anticipated volatility in stocks and bonds has desensitized many investors to the increased risks they are taking. So, too, is the conviction that the Fed will continue to bail out speculators.
Finally is Reason E. Loose mortgage lending has been encouraged by the development of mortgage-backed securities that allow lenders to package mortgage loans and sell the securities to yield-hungry investors. So, why not make riskier loans when they can be sold easily and the risks transferred with the sale? It's like a bookmaker who expands his business without adding risk by laying off his customers' bets to others.
89 Booming Cities
The countrywide scope of the bubble is clear from Chart 7. Remember that houses are extremely important assets for most Americans. Among households, 69% own their abodes compared with 50% who own stocks or mutual funds. And homeownership is relatively evenly spread among the population, in contrast to stocks, where ownership is skewed toward high-income people. So the breaking of the housing bubble will hurt the average American much more than did the collapse in stock prices in 2000-2002.
House sales have been falling for over a year. From their peak in June 2005 through September, existing single-family house sales have fallen 14%, and new home sales are down 22% from their July 2005 peak. Seasonally-adjusted existing house prices have declined 4.6% from their peak in October 2005, and even more than reported in view of the McMansion effect that has boosted their average size, and the home improvements that have increased their value.
Surveys indicate that homeowners use 35% of cash-out refinancing money for home improvements. Median prices of new homes plummeted 9.7% in September vs. a year earlier, and concessions by builders such as free vacations as well as the McMansion effect have added further to the weakness in actual selling prices of similar-sized new homes.
I continue to forecast a 25% fall in median single-family prices nationwide. This sounds like a big drop, and is far larger than the 5% to 10% decline that other housing bears foresee. But it would take a 35% fall to bring house prices back in line with the CPI (see Chart 1 from above) and a 40% plummet to re-establish the stable level of real quality-adjusted house prices that held in the previous post-World War II era (see Chart 2 from above). And recall that overblown markets don't just return to trend, but overshoot on the downside just as the housing market has on the upside.
Honey, I Just Sold Our House
Housing optimists obviously put our forecast out of mind. They, including former Fed Chairman Greenspan in earlier years, argue that housing can't experience a boom-bust like stocks because homeowners are house occupiers who need a place to live. Domestic bliss could be disrupted if a man suddenly announced to his wife and kids that he'd just sold their house, but had no idea where they will move. Furthermore, brokerage fees, title searches, mortgage fees, moving and redecorating expenses and other transaction costs, the bulls argued, make it prohibitively expensive to speculate in houses.
But many transaction costs have fallen sharply in recent years. Online realtors and the Justice Department are putting tremendous pressure on the previous cartel-set commissions of real estate brokers. And negating the place-to-live argument, speculators who own multiple single-family houses and condos have leaped in number. Those folks can quickly sell the houses they own beyond their abodes.
The National Association of Realtors' surveys reveal that in 2005, 28% of all home purchases were for investment and another 12% were vacation homes, for a total of 40%. We focus on this total number, believing that many second-home buyers, like investors, have speculative blood in their veins. They want a house in the mountains, but are much more inclined to buy if they expect to make a financial killing on it. In 2004, multiple home purchases were 36% of the total.
Related to their belief that massive speculation in houses was impossible was the bulls' conviction that sizable excess inventories would not develop. With almost every house sold to an owner-occupier, they believed, and with major home builders assuring everyone that they were only building to firm orders, how could unwanted inventories accumulate?
But firm orders proved to be far from firm since they require little of any downpayments in many cases. So builders have been shocked! shocked! when speculators walked away from those orders as prices flattened and they learned they were really building spec houses. And they've continued to build to complete development sections, keep their employees busy and keep overhead spread over as many units of output as possible.
Then there are the smaller builders whose assets consist of several pickup trucks and lists of subcontractors and lenders. Has human nature changed so much that they didn't build spec houses when prices were leaping as they did in past housing booms? On balance, new home inventories are leaping and as sales fall, the inventory-sales ratio, defined as the months' supply of new houses at current selling rates, is skyrocketing. As in any goods-producing industry, a jumping inventory-sales ratio is a sure sign of trouble.
It's the same story with existing houses. Sales are falling and inventories jumping as worried speculators and other owners put their houses on the market. So, the months' supply in September leaped 54% from a year earlier to 7.1 months.
Where's The Unemployment?
Many housing economists, realtors and homebuilders also don't believe housing can suffer big trouble as long as the economy is strong. With the unemployment rates relatively low and job markets improving, how can sellers be pressed into accepting "giveaway" prices? They also note that interest rates aren't high enough to bother many buyers.
But housing cycles always lead the economic ups and downs, not the other way around. Housing starts begin their usual 50% or greater decline before the peak of business at which time unemployment starts to rise.
Sure, housing slides are normally precipitated by interest rate jumps but these aren't normal times. Nationwide housing speculation is at an extreme not seen since the 1920s, as discussed earlier and shown vividly in Chart 2. This is a gigantic bubble that is bursting from its own overexpansion with very little help from rising interest rates.
Existing home prices in September fell 2.2% from a year earlier, the biggest drop in the 38 years of National Association of Realtors data. That matched the August decline and was the first back-to-back fall since 1995. In Massachusetts, median single-family prices fell 8.3% in September from a year earlier. Sales nationwide were off 14% over the 12 months, but outside housing, the economy remained strong.
Two Price-Break Triggers
Two scenarios can force house prices to step off their recent plateaus and catch up with the already severe declines in sales. The first, which we favor, calls for speculators to give up in hopes for appreciation, which for many is critical since the rental income on their properties falls short of their mortgage, taxes, maintenance and other costs. As they dump their housing on the market, prices will nosedive, which will encourage other worried sellers to do the same and generates a nationwide rout.
It's worse for speculators with vacant houses. Over half of existing homes for sale are vacant, and worried speculators are putting an increasing share of vacant properties on the market.
What about the over 40% of existing houses for sale that aren't vacant? The For Sale signs that are accumulating on affluent New York suburban lawns attest to the many who refuse to lower their prices to market levels. But those are owner-occupiers, not speculators, and they planned to move somewhere after they sold. (We're indebted to our good friend and client, Ron McGlynn of Cramer Rosenthal & McGlynn, for bringing up this issue.) So unless sales revive quickly, they'll be forced to back out of contracts to buy their next abodes, be they urban condos, suburban townhouses, retirement homes or residences in other cities. Or they'll each own two properties and be forced to unload one of them. The point is that the inventory overhang of these folks' residences breeds more inventories and weaker prices later on.
Past patterns suggest a two-year gap between the decline in house sales and the collapse in prices. But given the huge amount of speculation this time, the gap may be shorter, 1 1/2 years in our judgment. Since sales peaked in mid-2005, the big slide in prices might well commence roughly at the end of this year. And as builders and homeowners attempt to unload their properties while buyers evaporate, the months' supplies of new and existing homes will jump to the 8-10 month ranges (see Charts 11 and 12 from above).
The second price collapse trigger, mortgage rate-reset shock, takes longer. ARMs have been increasingly popular, especially since interest-only ARMs, accounting for 17% of all home mortgages in the first half, option ARMs, 9%, and ARMs with low initial rates allow many to buy houses they otherwise can't afford. Even then, many homeowners are financial pressed. A U.S. Census Bureau survey found that last year, 35% of Americans with mortgages spent 30% or more of household income on housing outlays while only 30% did so in 2003. In California, it was 48% and a number of other states had well over the national average. Gone are the days when 25% of income for housing was the standard!
Subprime mortgage loans have leaped in recent years as a portion of total originations, and among subprime mortgages, so have ARMs. Most of those subprime borrowers are especially stretched to meet monthly mortgage payments, and few have financial resources to fall back on if they lose their jobs or if their mortgage payments adjust up substantially. They already spend about 40% of their incomes on mortgage debt service. But payments will leap unless interest rates collapse--and soon.
Around 60% of subprime ARMs issued since 2004 have fixed interest rates for two years and float for 28 years thereafter--2/28 mortgages. Their original rates in 2004 were 7.1% on average and, under their mortgage contracts, can eventually adjust up to about six percentage points over the current short-term benchmark, the London Interbank Offered Rate (LIBOR) of about 5.4%, or to 11.4%. Wow!
So if speculator capitulation doesn't initiate a big house price decline soon, reset shock may well do so by late next year as subprime borrowers and some prime borrowers as well become delinquent on their mortgage loans, face foreclosures and are forced to sell.
Straws in the Wind
Both the pressure on speculators to sell and the mortgage rate-reset shocks will be magnified if prices start to tumble on their own. As noted earlier, seasonally-adjusted existing house prices haven't collapsed yet, but in September were down 4.6% from their October 2005 peak. The September numbers for new house prices, however, are the real shocker. Unseasonally-adjusted prices were down 9.3% from August and 9.7% from a year earlier, as noted earlier. Not surprisingly, the housing bulls are pooh-poohing the numbers, claiming they're a result of a changing price mix in sales and shifts in regional sales patterns.
But in the third quarter vs. a year ago, sales in the Northeast, where prices are the highest in the nation, fell 14%, less than the countrywide decline of 21% and prices rose 19% compared to the nationwide drop of 1.7%. These factors in themselves worked to raise, not cut, overall prices.
At the same time, nationwide mean prices fell 2.1% in September vs. September 2005 compared to the 9.7% fall in median prices. This suggests a shift to a cheaper mix of new house sales, which indeed the Census Bureau's data confirms. Sales in the $300,000 to $400,000 price range dropped from 16% to 11% of the total in September vs. 12 months earlier while rising from 21% to 26% in the $150,000 to $200,000 bracket.
Nevertheless, new home price weakness probably reflects more than anything else the zeal of builders to slash prices, make huge concessions and do anything else to unload their inventory. Indeed, nationwide sales were up 5.3% from August, reflecting their zeal to sell, but still down 14% from September 2005. Still, homebuilders are far from out of the woods. The months' supply of unsold new houses is still about double its size several years ago (see Chart 11 from above).
This pressure to unload new houses is a taste of what we expect to be swallowed in existing structures when speculators start to dump their properties on the market for whatever they will bring. Indeed, the nosedive in new home prices and continuing aggressive selling by homebuilders may speed up the collapse in existing house prices by scaring potential worried sellers into action as buyers turn to new homes rather than old.
Furthermore, note the downward revisions in the estimates of new home sales and upward revisions in inventories since their initial releases. This is very typical of falling markets where data are weaker--in the case of new home sales--and stronger--in terms of unwanted inventories--in retrospect.
There is a concrete reason for this phenomenon. The data producers want to release their various series while they're still timely, but that's usually before all their sample results have been received and tabulated. So they base their initial estimates on partial samples, supplemented with recent trends in the series in question. This works well when a series is rising or falling at a fairly steady rate, but not at turning points when it is accelerating or decelerating. So, statisticians normally overstate reality when the economy is weakening and understate it when business is recovering.
As usual, the airtight case we've made for a collapse in house prices just might have a few leaks. We can think of several possible offsets that could moderate housing weakness or offset at least some of its negative effects on the overall economy.
Some argue that the recent drop in gasoline prices is a huge windfall for consumers that will offset much of any evaporation in house appreciation in supporting consumer spending. Since gasoline accounts for 3.7% of consumer spending, this decline increases consumer purchasing power by 1.0%.
But this decline is small compared with the money that homeowners have been extracting from their abodes. The Federal Reserve estimates that last year, they took $719 billion out of their abodes and spent half of it on goods and services. That's 4.1% of consumer outlays, or about four times the effect of the drop in gasoline prices. Furthermore, except for weak Wal-Mart sales to its low-income shoppers, there is little evidence that consumers depressed their spending on non-gasoline purchases as fuel prices rose in recent years, so why should they act in the opposite way with the recent price decline?
We've pointed out many times that American consumers have been using house appreciation to fund the gap between subdued income and much more robust spending growth. They extracted money with refinancing and home equity loans. Or they've borrowed more on credit cards and saved less, if they save at all, because they regard their houses' appreciation as continually-filling piggy banks that will fund their kids' education, early retirement and a few round the world trips in between--what economists call the real wealth effect.
We've also noted that in the first 19 quarters of business recovery since the recession's bottom in the fourth quarter of 2001 (the third quarter of this year has not yet been reported), the employment cost index, the Fed's favorite measure, has risen at an annual rate of 0.6% in real terms. And note that this measure overstates what people are actually paid in wages and salaries and benefits since it excludes the chronic shift from high-paid industries like manufacturing and utilities to low-paid sectors such as leisure and hospitality.
In contrast, in the 19 quarters through the last quarter, real consumer spending has grown at a 3.1% annual rate. The 2.5 percentage point gap is huge and indicates the extent to which house appreciation has funded consumer spending growth.
Some argue, however, that a broader measure of income than the ECI is appropriate, namely real disposable (after-tax) income, which also includes proprietors' income; rental, interest and dividend income; pension fund contributions and Social Security benefits. This measure has grown at a 2.8% annual rate in real terms in the last 19 quarters, still below the 3.1% real consumption growth rate but much closer.
Still, we believe the ECI is the right measure since pension fund contributions aren't paid out and can't be used to fund spending. Also, little of rental, interest and dividend income is received by middle- and lower-income people who have been more reliant on house appreciation to fund their spending. In fact, the total ECI we're using includes health and other benefits that generally can't be used for discretionary consumer spending. The real wage and salary component alone actually declined at a 0.1% annual rate in those 19 quarters.
The Fed to the Rescue?
Massive ease by the Fed coming very soon could stem the collapse in house prices. Speculators and builders might take heart and forestall selling, and the mortgage rate-reset shock could be largely eliminated if the Fed dropped its federal funds rate back to its earlier low of 1% quickly.
But such dramatic action by the Fed is unlikely soon enough to save the day. The central bank doesn't change its policy on the basis of forecasts but in response to current developments. And like all good credit authorities, the Fed officials are congenitally worried about inflation. They don't want to risk reducing rates prematurely and then seeing inflation and the economy take off like scalded dogs. That would make them look like toothless tigers, and they'd have to really squeeze credit and kill the economy to re-establish credibility.
So, the Fed won't ease until housing is clearly collapsing and the resulting recession prospects obvious. This point may come early next year, but the Fed's patriotic rate-cutting then will come too late to reverse the downward housing spiral. Given the prospects for a severe U.S. and global recession, however, an eventual return to a 1% federal funds rate is indeed likely.
A Federal Bailout
Housing is so important to the U.S. economy and the American dream that it's very hard to believe that a collapse of the size we foresee could occur without a significant reaction from the Administration and Congress. With a 25% drop in existing median single-family house prices nationwide, sales will fall 60% or more from their June 2005 peak. Many homebuilders will go out of business and lending will switch from smiling distributors of more-than-ample funds to chastened tightwads who won't lend to anyone except those who don't need to borrow. Delinquencies on subprime mortgages will probably double from their current 8% rate.
What might Washington do? So many mortgages have been securitized in recent years that investment risk has been spread beyond conventional lenders. But that doesn't reduce the damage of foreclosures to hapless homeowners. Washington may end up using moral suasion and good old money to encourage lenders not to foreclose and otherwise mitigate dire consequences for homeowners that would lead to even weaker house prices as foreclosed houses are dumped on the market.
Banks and other mortgage lenders will be only too happy to cooperate with government bailout efforts, which will save their skins too. Nevertheless, the lucrative fees they make for residential real estate lending will be history.
The federal bailout of the S&L industry in the late 1980s-early 1990s may shed some light on what's ahead. The thrift industry troubles back then arose from factors that parallel today's global excess liquidity, low concern over risks, blind search for high returns, speculative fervor and the loose mortgage lending practices that have resulted. Looking back at that time, it's clear that government only acts on a major financial problem after the fact and is slow to fathom its depth. Confusion reigns as different and even competing government agencies lack consistent strategies. Meanwhile, the problem feeds on itself. Let's hope that the experience of the S&L crisis two decades ago results in earlier understanding of the housing troubles and their extent, earlier actions and better management and coordination among the participating government bodies. But don't bet on it.
The Bad News
A move from high to no or even low rates of house appreciation would probably force many to live within their incomes, with significant negative effects. Of course, the more house prices fall, the quicker they will accept the demise of rapid real estate appreciation and adjust down their spending.
The 25% or greater decline in house prices we foresee will sire considerable consumer spending retrenchment that almost guarantee a major recession. Note the close link between the Homebuilders' Sentiment Index, which has collapsed, and real consumer spending.
And that consumer spending weakness will come on top of the negative economic effects of a drying up of housing activity. Housing-related employment, including builders, brokers, lenders and mortgage brokers, has accounted for about one-quarter of job gains in this business expansion, and most of those positions enjoy above-average pay.
Fed Chairman Bernanke said that housing weakness could knock 1% off real GDP growth. It did so, 1.12% at annual rates, in the third quarter, after a 0.72% negative effect in the second quarter. That, of course, is what the housing bulls hope will be the bottom of residential construction weakness. They also hope house appreciation will return to a roughly 5% annual rate, enough to keep speculators from bailing out and enough to allow subprime mortgage borrowers to refinance and avoid disastrous mortgage rate-reset shocks.
The housing bulls are hardly prepared for the 5% to 10% peak-to-trough decline in prices that other housing bears and the futures market predict. The futures market indicates that the Case-Shiller Housing price index will decline 7.5% from its June 2006 peak to August 2007. Using median existing single-family house prices nationwide, a somewhat different series, we expect the decline of 4.6% from their October 2005 peaks to September of this year to extend to 18% by the third quarter of 2007 and to nosedive over 25% from the earlier peak to the final trough in the first quarter of 2008.
In contrast to Bernanke's forecast of a 1 percentage point drop in annual rate GDP growth from housing weakness, we see more like 5 or 6 percentage points. The 3% trend growth will turn into a recessionary decline of 2% to 3%. Especially hard hit by falling house prices and the recession will be the subprime borrowers that the government, through Fannie Mae and Freddie Mac, has been enticing into homeownership. The idea is that if low-income, young and minority people own houses, they'll have stable families and neighborhoods. These programs, fueled by 3% or lower downpayments, have worked in increasing their homeownership. But many of those people have small or negative net worths outside their houses and little discretionary income. They're basically living hand to mouth.
In the recession, these low-income folks will suffer widespread layoffs and will default on their mortgage payments. In addition, their house-buying will dry up. So those a rung up the ladder who would normally sell their starter houses to low-income people and move to higher-priced digs will be stymied as will successive links on the up the move-up chain, all the way to the McMansions of Reginald van Gleason III.
Deflation and Treasury's
A major global recession initiated by a collapse in U.S. house prices will probably usher in the chronic deflation we've been forecasting. Crude oil and other commodity prices will nosedive along with all fears of inflation. This deflation of 1% to 2% annual declines in major price indices will be the good deflation of tech-led, productivity-soaked excess supply, much like the late 1800s and the 1920s when concentrations of new technology propelled supply faster than demand increased. Nevertheless, a complete breakdown in housing and stubborn mortgage debt burdens could spawn the bad deflation of deficient demand, as in the 1930s in the U.S. and in Japan more recently, as consumer spending becomes moribund.
Regardless, the next year or so will probably be miserable for most stocks, but great for Treasury bonds as these ultimate safe havens rally as their yields follow inflation rates down. What we luckily identified as "the bond rally of a lifetime" in 1981 when Treasury bond yields peaked at 14.7% will continue toward our ultimate target of 3% yields. If this occurs over two years, so two years of interest are added to capital appreciation, the 30-year Treasury bond will enjoy a total return of about 50% as its yield falls from the current 4.8% to 3.0%. The 30-year zero coupon bond will return even more, around 80%.
Some Observations On The Big Easy
I have been coming to New Orleans, aka The Big Easy, for over 20 years. I love this city. Some great memories made with close friends have come in this town. I first came as young newspaper boy (I won a sales contest for the Dallas Morning News) when I was 14. There was a time when you could hear Lionel Hampton, Al Hirt and Pete Fountain on Bourbon Street all a few blocks from each other, then in the 80's Bourbon Street went really seedy. In the 90's it was cleaned up somewhat, but there were all these marvelous hoe in the wall clubs where you could hear real blues and a few really good Irish bars with live Celtic music. And of course the food. Commander's Palace is one of the world's great establishments. Antoine's, Arnoud's, the list is so long.
Yesterday I walked through the quarter on the way to dinner. It was rather sad. There were still all the music places, but they all had cover bands playing the same music (way too loud) you get in any city in America. While the side streets were clean, Bourbon Street itself was borderline nasty. Too many strip clubs, too much mediocre music and not enough of the soul of the Big Easy. It was sad. I hope while they are rebuilding this city that someone remembers what gave it life and character.
But the good news is that so many friends came to this conference. Many of us have been attending for over 25 years. The "hard money" crowd that Jim Blanchard would gather still comes to celebrate his memory and the yellow barbarous relic. I am here with my daughter, and she gets to hear stories about old friends (and dad) and what the business was like all those years ago. Seeing it through "fresh" eyes makes me realize what a fun and blessed life I have had.
It is time to hit the send button. I want to hear Newt Gingrich this morning. Have a great week and take some time to call a friend and share some memories. It will keep you young.
Your really wishing he could hear some great blues analyst,
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