Monday, July 30, 2007

Housing's Three Black Swans

Conventional wisdom holds that real estate declines are slow, orderly trends which unfold over many years. But could the housing market be as primed for a "Black Swan Event" as the stock market?

Let's look at a chart of the last housing decline, circa 1990-1996, courtesy of Lee Williams and the California Housing Forecast. The light-blue line traces the 17% decline in San Diego housing in that 7-year period, as reflected by the Case-Shiller Index. The dark blue line traces the current housing bust's decline. (Lee William's detailed article on Housing Affordability is posted on Schahrzad Berkland's excellent California Housing Forecast.)

The red lines trace "improbably rapid" declines--i.e. Black Swan events.

Please visit to see the charts.

Lest you think that sudden changes are virtually impossible, please consider Lee's chart of Notices of Default and foreclosures:

And lest you think this parabolic rise is only a San Diego phenomenon, please read this front-page feature in the 7/29/07 San Francisco Chronicle: LIVING THE AMERICAN NIGHTMARE: FORECLOSURES ON THE RISE:

"This year, almost 1 million people nationwide will enter a stage of foreclosure, according to That great tidal wave is ravaging the already beleaguered real estate market and causing repercussions from Wall Street to Washington, D.C.

In the second quarter of this year, 2,206 homes in the nine-county Bay Area were lost to foreclosure, according to real estate service DataQuick Information Systems. That was the highest number for this area since DataQuick started tracking foreclosures in 1988, and an almost nine-fold increase from 258 foreclosures in the April-June period last year. Also in the second quarter, DataQuick said 7,696 Bay Area homeowners received notices that they were in default on their mortgage payments -- the first step in the foreclosure process. That was more than double the 2,910 default notices received at the same time last year. "

The popular book (recommended here by U. Doran) by Nassim Nicholas Taleb The Black Swan: The Impact of the Highly Improbable describes how amazingly often supposedly unlikely events occur in the real world. Risk cannot be banished forever; at best it is driven into hibernation. Just as we are seeing a re-emergence of risk in global stock markets, it appears that an "improbably rapid" meltdown in the housing market is underway.

The factors triggering a landslide of NODs and foreclosures are gathering momentum with every passing day:

1. Fixed-rate mortgages have climbed to 6.70%. This is a far cry from the bottom rates of 5% of a few years ago. The jump from 5.2% to 6.7% may not look like much, but it's a jump of 29% --a staggering increase in the cash needed every month to service a mortgage.

2. Fewer borrowers qualify for the best rates. In the above S.F. Chronicle story, one self-employed borrower re-financed his initial loan. His new rate: 10.5%. Rather than track the "best rate" being advertised, perhaps we should be tracking the "real rate" desperate re-financers are accepting as credit tightens.

3. Real rates being offered to borrowers and those trying to re-finance are steep. The difference between 6.7% and 10.5% is 3.8% -- a staggering 56% premium over the headline rate. That translates into a payment which is $19,000 more per year on a $500,000 loan. ($52,500 - $33,500 = $19,000)

4. The focus on subprime borrowers glosses over the HELOC homeowners (home equity loans) who are underwater. As one of the cases in the above story illustrates, homeowners who extracted most of their home equity in the belief that the rise in their wealth was never-ending are discovering that the sag in house prices has dropped them underwater. As their home equity loans re-set, they find they can no longer afford their once-affordable home.

5. Prices are dropping much faster than statistics reflect. Another case described in the S.F. Chronicle piece describes a property which was appraised for $630,000 in January that now has a "real time" market value of about $455,000.

6. Buyers at the peak in 2004-5 have hung on as long as they can, and are now capitulating en masse. As crazy as it sounds to those of us from an earlier era, buyers with incomes of $2,600/month willingly accepted mortgages with payments of $2,600/month--not including taxes and insurance. By working weekends, borrowing, etc., many of these buyers have managed to make these back-breaking payments for a few years. But now the well has run dry, and they are falling off an unavoidable financial cliff.

As my notes on the chart suggest, there is a generational element to these waves of default and foreclosure. Generation Y (those in their 20s) have no memory of the last downturn in the early 1990s, so they were quickly caught up in the get-rich-quick, housing-never-goes-down mania of the 2000-2005 period. Buying with no money down and accepting "liar loans" with equanimity, they are the first to bail out. Lacking any equity and with few prospects for jumps in wages gigantic enough to cover their rising payments, the decision to get out is painful but unavoidable.

The next Black Swan Sighting will occur next year, when Gen-Xers start losing their jobs. Those in their 30s are cushioned from the sudden decline in values by virtue of their buying into the housing market earlier, in the late 90s and dot-com bust era (2000-2003). The fabulous increases of 2004-5 left buyers on the Left and Right Coasts with enough equity to ride out declines, and time to re-finance out of adjustable-rate loans into fixed-rate mortgages before credit tightened.

But Gen-Xers are heavily dependent on high-paying jobs. Once one spouse loses a big-bucks job, the debt-bomb starts ticking. As the economy sink rapidly into a long-delayed, deep recession, job losses will decimate wage-earners' ability to keep up huge mortgage payments.

Gen-Xers' parents are very much alive and kicking, and facing their own financial woes (see below), so unlike the older Baby Boomers, Gen-Xers can't hope to inherit a fortune or a free-and-clear house to save them. They will cling on as long as possible, hoping to find jobs which pay the same as the ones they lost, but when that search becomes futile, then they will be forced to liquidate/sell en masse. This will trigger another Black Swan decline in housing.

The Baby Boomers have the equity, but as they lose their health insurance and suffer health issues, they too are being forced into bankruptcy. This unexpected process is already playing out nationally, as Boomers juggle helping their parents and offspring while their own health suffers the usual slings and arrows of advancing age.

The Boomers are in a triple vise: they are as dependent on high-paying jobs as Gen-Xers, and even less likely to find replacement jobs as the recession lays waste to the U.S. economy. Many have spent freely of their equity (via home equity lines of credit -HELOCs) even as they counted on the ever-rising equity in their homes to fund their retirement. A single health crisis--or a health crisis in a parent--can be a tipping point which pushes the family into a financial slide which leads to foreclosure or bankruptcy.

As retirement looms, even healthy Baby Boomers start realizing their retirement dreams are fading as housing drops. Just as in the stock market, you can watch profits vanish for only so long, and then you sell to retain what little is left. This panic selling by soon-to-retire Boomers will trigger the final Third Black Swan decline.

The notion that 76 million Baby Boomers can all sell their primary residences to the following generation of 40 million at sky-high prices... do you see a wee disconnect here? If you examine U.S. demographics in the broadest terms, it becomes abundantly clear that housing will be in over-supply for decades to come. Yes, there will be immigration, but less as the recession dries up employment. And most immigrants are coming to work in low-paying jobs; they will not be buying a Manhattan condo or a Santa Monica bungalow or even a McMansion in Phoenix.

As these demographic realities become visible, the rush to the exits will become a stampede, making the resulting drop far deeper and faster than anyone expected. Many Baby Boomers rushing to cash out already own a second or third home purchased in the bubble; they have no need to buy another home. So as their main residences flood the market, raising inventory ever higher--who's going to be buying these millions of houses and condos?

For those who wish to explore generational and demographic issues further, I recommend The Fourth Turning (recommended by correspondent Matt)

Fewer: How the New Demography of Depopulation Will Shape Our Future

and The Coming Generational Storm: What You Need to Know about America's Economic Future.

And speaking of Black Swans, here is haiku from reader/contributor Allan J.

Bears laugh, Bulls cry
the Black Swan wings
land rough sea

jagged graph down
lightning jag up
wind blows old

the dashes, the flashes
the tears, the glimmers
the nerves of fists

my oil house cold
our country closet bare
war nags our children

hearts darken, adrift
eyes burn to see
history quivers voice

Thank you, Allan, for these thoughtful verses. I am also grateful to frequent contributor Bill Murath for his kind words on the Haiku which has graced these pages:

"It is so cool that in amongst all the economic and political essays you can throw in Haiku as a topic and then have numerous readers contribute some excellent pieces. I will not add much more since this is meant as a sincere high five, but I was just thinking that of all the blogs I read not one could pull this off.

Most excellent!"

I must credit longtime correspondent UKC (our first UK correspondent way back when) for the brilliant suggestion of eliciting Haiku from this site's creative, erudite, witty readers. Thank you, UKC, and thank you, readers.

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