Monday, October 22, 2007

This Week's Theme: Harsh Realities

Housing Declines: Don't Forget About Inflation


The real estate industry's Standard Model can be summed up as: "real estate never declines." Alas, reality has rudely disrupted this model--not just currently, but in the recent past.


As people worry and wonder "where's the bottom?" it is instructive to look at the last decline in real estate values during the 1990-1997 period. (It isn't exactly ancient history, folks.)

And even though many sprawling markets in the U.S. have experienced declines of 20% to 40% from the November 2005 bubble top even as a few others (Manhattan and Montana) have edged higher, let's work with the averages rather than the extremes.

With this in mind, let's look at reality: both the reality of nominal and inflation-adjusted declines in 1990-1997, and also the current decline in value:



Let's start with history. The decline in housing 1990-97 should be placed in the context of the very mild recession 1990-91 and relatively moderate borrowing costs (30-year mortgages were in the neighborhood of 7.5%.) Yet even with a growing economy and benign borrowing costs, real estate declined for 7 years both in nominal and inflation-adjusted prices.

If you kept $100,000 stashed in cash under your floorboards from 1990 to 1997, your cash lost 23% of its buying power. (You can check this yourself by going to Bureau of Labor Statistics Consumer Price Index website.) We all know "official inflation" is grossly understated as a matter of policy, so this 23% decline in purchasing power is extremely conservative.

Here's another way to illustrate the loss of value experienced by homeowners 1990-97: how many loaves of bread did it take to buy a house? A close friend (and very smart guy) put it this way in a recent conversation, and this brilliantly captures the heart of the matter: "how many loaves of bread" is a visceral analogy for inflation-adjusted purchasing power. The price of a house as measured by loaves of bread rather than depreciating dollars captures the real value of the house rather than its deceptive nominal price.

Priced in loaves of bread, house prices fell 40% from 1990-97. That is a simple undeniable fact. You can look up all the statistics in a few minutes on the web. But naturally the vast real estate and lending industries don't publish inflation-adjusted charts because they reflect the damning truth: real estate experiences bone-crushing losses in actual (purchasing power/inflation-adjusted) value.

The "real estate never declines" mantra has already been destroyed by fact. Outside of corners of Montana and a few other outliers, housing values have dropped in nominal terms virtually everywhere. To keep things simple, let's use the average of a 7% decline since the November 2005 top.

(NOTE: there are numerous opportunities for fun-with-statistics here. Shouldn't declines be weighted like stocks in the Dow Jones Industrial Average? In other words, shouldn't the 20% declines in vast swaths of high-priced, 36-million-residents California be weighted more than modest declines in smaller markets? Should houses above $1 million be excluded as they distort the average and median prices? I would say yes to both. In other words: median and average prices and declines are easily and routinely manipulated.

The most egregious is "median prices." A handful of $5 million homes selling will increase the area's median price even as 90% of the houses decline in value. Does this statistic reflect reality? Of course it doesn't--but it sure looks better to the industry.)

But even if housing prices stayed nailed in place (at $500,000 in the above chart), modest inflation slowly but surely eats away a third of the property's real value. Currently inflation is officially running 3-4% (please ignore the phony 2% "core inflation" hyped by the Fed's spinweisters); more realistic/less manipulated calculations conclude actual inflation more on the order of 6-7%. (Please read Shadow Government Statistics:)

Gimmicked Data Appear Aimed at Reducing Pressures on Fed for Another Easing / September M3 Annual Growth Hit 14.7% / Watch Out for CPI Annual Inflation Surge!

In other words: priced in loaves of bread, house values might actually decline 50% even as their nominal value appears to be stable. That is the painful effect of inflation: eroding purchasing power and eroding assets.

Housing is already declining in nominal terms. At this late date, even the shills and hypsters concede this undeniable reality. So let's assemble the most reasonable, fact-based assumptions:

1. housing declined in nominal terms 1990-1997. You can look it up.

2. housing has already declined 7% or so from its bubble top 11/05. In some places, the bubble top was mid-2006; regardless of the quibbles, nominal prices are declining virtually everywhere except in limited outliers where values are generally distorted by the sales of extremely pricey homes.

3. Even with the absurdly underestimated "official inflation" numbers, housing has taken a 6% hit since Nov. 2005. Did your house deposit 4% interest on its $500,000 purported value into your bank account like $500,000 in Treasury bonds did ($20,000)? No? Then it lost value, didn't it? Price it in loaves of bread and you get the same result.

If we extend these modest declines in both nominal and inflation-adjusted values to the same seven-year stretch of the last decline, we end up with staggering losses in real value.

Given that this bubble reached extremes far beyond the rise in housing 1983-1989--extremes in valuation, extremes in lending, extremes in interest rates and extremes in speculative frenzy--common sense suggests any declines would be even longer and deeper than those experienced in 1990-97.

Not only that, but consider the future effects of the credit contraction and the destruction of a trillion dollars in lending power. That is, no one will be writing any more CDOs, MBS or SIVs for years to come. All that easy money is gone, gone, gone and won't be coming back.

Also note that inventories are at record levels, with millions more units (new homes, foreclosed houses and all those speculative units "purchased to flip") in the pipeline. Overbuilding also reached an extreme.

And interest rates? Even as the Fed cut its rate by a half-point, mortgage rates actually rose. Recall that the Fed doesn't set mortgage or T-Bill rates--the market does. The Fed rate can drop to 1% again and if nobody's buying bogus risky debt any longer, then 30-year mortgages could be 9%. Don't believe it? It's already happening. Long-term rates are rising even as the Fed flails and churns, dropping its Fed Fund Rate.

In other words, there is every reason to expect the current downtrend to be longer and deeper than the 1990s decline. Extending the heretofore modest declines out five more years is thus extremely conservative.

Even with these conservative estimates, the actual value of a $500,000 house (January 2006) will decline to $300,000 by 2013.

Some will argue: but the bottom is almost here now. That begs the question: why wouldn't the real estate cycle repeat the historic pattern of "X years up is followed by X years down"? With so many extremes all blowing up at once--extremes of inventory, mortgage debt, total indebtedness, interest rates, lax lending, derivatives marked to myth/fantasy/model, and so on-- what conditions exist in reality that support a "the bottom is now" claim? None.

In conclusion: the above chart reflects a "best-case scenario." The worst-case scenario I leave to your imagination, for we are truly in uncharted waters.


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