Without a doubt, Alt-A and option ARMs are already causing problems internally on the balance sheet of banks:

Since 58% of option ARMs are here in California, this combined with the fiscal problems of the state will prove to put housing into a precarious state for the next few years.  Let us look at 10 charts as to why the California economy and real estate market will see no recovery in 2010.
Chart #1 – $21 Billion in Budget Deficits

Without a doubt, these are enormous budget deficits that we need to contend with.  In the last cycle, the state had to cut spending and also raise taxes.  There were also many gimmicks in the last fiscal budget since the state government was hoping for a Hail Mary pass that the economy would somehow recover in a few short months.  That didn’t happen and the gap has opened up again.  Combine the current fiscal year and the next, and we are looking at $21 billion to patch up.  Where is this going to come from?

Chart #2 – Deficits for Many Years

One of the large issues in the latest fix is cuts that were supposed to happen but didn’t.  For example, the correction system is over budget by $1.4 billion and Medi-Cal spending is over by $900 million.  If you don’t adhere to a budget, then problems will occur.  But this is more kicking the can down the road budgeting yet the reality is, California hasn’t improved much in the last year.  In fact, unemployment is now up to a record keeping high of 12.5 percent.  Is this good news for the California housing market?

Chart #3 – Optimistic Outlook

The California LAO does a good job at looking at data but their forecasts are a bit optimistic.  If you look at the above chart, the peak unemployment rate for the U.S. is 10 percent and for California it stands at 12.1 percent.  We are already beyond those points.  Given, these are yearly averages but so far the trend is moving in one way.  You will also notice that for California, the LAO sees a doubling in housing permits for 2010 and nearly a tripling by 2011.  So far, we have seen little reason to assume this is going to happen.  With many more foreclosures coming in the future through Alt-A and option ARMs, we are assured more inventory in the next few years.

Chart #4 – U.S. GDP Moves Sideways

The above is the optimistic scenario.  In fact, even the LAO is bringing up the Japan lost decade as a possible outcome.  I’ve talked about the Heisei boom and bust in Japan and mentioned this as a possible outcome for us.  Given the current government measures and actions, we will be lucky to have a Japan like outcome.  At this point, the Fed is trying everything it can to keep any audit from occurring since so much toxic financial waste is being funneled into that balance sheet.  So much for transparency.  What the Fed is basically saying is if you take an honest look at what they have, the economy will implode.  How is that for confidence?  The Fed will make Bernard Madoff look like a small town bank robber.
The above flat lining or “V” shaped recovery is not going to happen.  It is simply too optimistic.

Chart #5 – California Weak Housing Price Growth

You would think with budget deficits until 2015, unemployment at 12.5 percent, and a political system that resembles a developing nation, that all of that might throw a wrench into the housing growth crowd.  No way!  It is the immaculate housing recovery.  Who needs jobs for the stock market to go up 60 percent?  Like Wall Street, some people think that housing can recover even if the economy is in a mini-depression.  And in the current budget that we enacted, revenues are a problem but spending is the bigger issue.

In the July budget it was assumed revenues of $84.1 billion for 2008-09 and $89.5 billion for 2009-10.  So far, this year revenue is lower and LAO expects revenues of $83.6 billion for 2008-09, $496 million less than budgeted and $88.1 billion in 2009-10 and that is $1.5 billion less than budgeted.  Yet areas like corrections are over budget by $1.4 billion and Medi-Cal coming in over by $900 million.

So what does this have to do with housing prices?  A lot actually.  There is only a few ways to balance this out.  More cuts (higher unemployment), higher revenues (taxes), or more likely a combination of both.  With elections next year, you can rest assured candidates for Governor are going to be focusing on the economy as issue number one.  Either way, the average Californian is going to have less money one way or another.  The Alt-A and option ARM problem is unique.  This housing bubble is unique.  We have no historical parallel.  How can it be assumed that this will simply disappear with no repercussions like dirt being swept under the rug?  Some think that HAMP or other gimmicks are going to stem the losses.  An unemployed person is not going to be able to cover a $200,000, $300,000 or $400,000 mortgage (fixed, Alt-A, option ARM, subprime, interest only, etc) so how are prices going to go up?

Prices are going up right now for the following reasons:

=Tax credit

=Artificial lowering of inventory (big shadow inventory)

=Moratoriums like HAMP

=FHA insured loans – 2% in SoCal two years ago now nearly 40% of all purchases
We already know how disastrous FHA is becoming.  Defaults are flying off a cliff.  The median down payment for FHA insured loans is 3.5 percent.  Are some putting down more?  Yes.  But half are not.  Plus, California is in a total mess:

“(LA Times) The credit information supplier says that during the third quarter, nearly 10.2% of home loans in the Golden State were 60 days or more past due. That was up from 9.7% in the second quarter and 5.8% in the third quarter of 2008.”

Nationwide things are equally as bad:

“(UPI) In records going back to 1972, the delinquency rate in the third quarter was an all-time high, breaking the previous high of 8.86 percent set in the previous quarter.

The rate does not include loans in the process of foreclosure which, separately, was 4.47 percent in the third quarter. The combined delinquency and foreclosure rate was 14.41 percent, also a record, the MBA said.”

In other words, 1 out of 7 mortgages is in some form of distress.  So the government is left with hard choices.  FHA insured loans are imploding because of the pathetically low money down required (3.5%).  FHA is going to need a bailout in the next few months.  But some are going to expect a pound of flesh.  The only way to combat this is by increasing the down payment requirement to at least 10 percent.  No one is saying eliminate FHA but come on, is 10 percent too much to ask for?  Do that, and the California market is done.  Yet the median nationwide home price is around $177,000; all you need is $6,195 to buy a home!  In Southern California, that can be your first month and last month deposit on a leased place.  Without significant changes the nation is going to have to bailout all the additional failed mortgages coming from California that have a much higher average balance.  This isn’t speculation, this is already happening.

Chart #6 – New Demographics

I talk to many younger couples and many are waiting to have families.  The above chart merely verifies this trend.  “Family forming” is a big mover in people buying homes.  No longer does the couple feel like their apartment is big enough for a child so off they go to buy a home.  But if people are waiting longer, it is expected that many may not have that rush or desire to buy sooner.  People are hunkering down.  In fact, in some areas of the country people are lining up outside of Wal-Marts at the end of the month waiting for paychecks or government funds to clear just so they can buy food.

So people are shifting priorities.  In fact, just from speaking to many younger couples, they are perfectly fine in waiting.  Their primary concern is trying to survive through the recession first before making the biggest purchase of their life.  So this throws another factor into the bullish housing argument.  Many couples don’t “need” to buy a home because they are delaying having kids.  Nothing wrong with that.

Chart #7 – Revenues from Volatile Sources

We have discussed that California receives revenues from very volatile sources.  Over half of all revenues for California comes from personal income taxes.  So with unemployment going sky high, it is no stunner that the state all of a sudden isn’t flush with money.  California has been artificially stimulated for two decades.  We had the tech bubble followed by the housing bubble.  There is no other bubble this time so we are basically fixing structural problems that have been decades in the making.  The forecast is dismal but as you can see, we suddenly see a miraculous recovery sprouting out like a card from David Blaine’s hand.  The LAO does a great job dissecting the numbers but doesn’t tell us what industries are going to make up for the lost income.

Also, the LAO is factoring in that COLAs are not going to happen for workers until 2015.  More reason to believe housing is going to go up right?

Chart #8 – Capital Gains

Within the personal income tax revenue section, a big portion of money comes from the wealthy, many who depend on the stock market casino.  If you look at the above chart, you can see how much money can come from capital gains.  During the tech bubble the state was pulling in 11 percent of the total PIT from capital gains!  It peaked over 8 percent in the real estate bubble but is now down to 2 percent.  The U.S. Treasury and Federal Reserve have juiced the stock markets because clearly the average American is not feeling any of the trillions in bailouts.  Their belief is that crumbs will fall from the plates of the banking oligarchs and trickle down to the middle class.  It is hard to believe that with the wild California housing market, cap gains didn’t match the tech boom.

Chart #9 – Unemployment

Good luck finding any real estate analyst that connects housing prices to employment and income.  Like Wall Street, the real estate market doesn’t depend on income and jobs anymore according to this new version of the economy.  The official unemployment rate is 12.5 percent, a record keeping high.  If we look deeper into the data, 23 percent of the workforce is either unemployed or underemployed.  If you are working at a local retail store after losing your good paying job, you are considered fully employed.  If you are working 10 hours at your local Wal-Mart to pay for food but want full-time employment, you are not part of that 12.5 percent.

Employment is such an obvious data point in terms of looking at any housing price movement.  Recent data is showing prime mortgages defaulting in mass not because mortgages are toxic like Alt-A and option ARMs, but because people have now lost their jobs or have seen their incomes fall by the wayside.  Until employment stabilizes, housing recovery talk is nonsense.  People right now are focused more on taking care of their immediate needs as they should.  Yet where do we focus our energy?  Banking bailouts, cash for clunkers, and home buying tax credits.  I’ve been living in this Alice in Wonderland world long enough that being in this sunny rabbit hole we call Southern California, nothing else really surprises me.

And one thing people miss even with FHA insured loans is the amount of leverage that is now gone because of Alt-A and options ARMs:

Take for example the above case.  Say you are looking at a good area like Culver City since I’ve discussed that area over the last year.  You are looking at a nice place that is going for $500,000.  The required household income is approximately $125,000.  Not out of reach for a working class couple.  So you can buy a home that is roughly 4 times your annual gross income.  Yet during the bubble, it was common for people making $50,000 to take on $500,000 mortgages.  Countless Real Homes of Genius were purchased like this.  But that leverage is now gone.  And keep in mind, if employment keeps faltering what if one couple gets hours cut back or fired?  FHA is providing roughly 4 times annual income leverage versus the ten (or even higher) during the bubble days.

Chart #10 – Unemployment Insurance

With so many people unemployed, the unemployment insurance fund has been running in the red for nearly a year.  We are in the hole to the tune of $4 billion.  The money is coming from somewhere:

“Because of the insolvency, EDD obtains federal loans on a quarterly basis to cover projected fund deficits. To date, the state has borrowed about $4 billion, permitting California to make benefit payments to UI claimants without interruption. Federal loans lasting more than one year generally will accumulate interest charges of about 5 percent per year on the outstanding balance.”

More debt and more borrowing.  We are loaded up with so much debt, that by 2015 the general fund is going to go to debt service and retirement benefits.

All this of course is somehow good for the housing market.  Yeah right.  No need for apocalypse movies when our budgets are this bad.

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Forget about the 2012 Apocalypse Movies because California has Enough Problems in 2010. 10 Charts showing why there will be no Economic or Housing Recovery for California in 2010. Unemployment at 12.5 Percent and $21 Billion in Deficits don’t Help Either.

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The market dynamics are fascinating.  I put together a comprehensive chart examining Southern California breaking out counties:

So what is happening?  The overall median price for the region is still near the trough.  The hardest hit regions of Riverside and San Bernardino are still near the bottom.  The slight uptick in these regions are based on first time homebuyers and investors.  In many of these areas, buying is on par with renting.  So that is one facet of the market.  On the other end, you have a county like Orange bouncing from their bottom.  Still a far cry from their peak but you are seeing more homes sell.  A couple of patterns here.  More lenders are willing to do bigger ticket short sales and this is moving prices up.  It is fascinating that they are hovering around the $417,000 mark.  The jumbo market is non-existent.  It will be fascinating to see what it does at this point.  Los Angeles has moved up slightly from the bottom.

We are still far from ever reaching a peak sales month like the few months we cracked the 35,000 mark.  Sales are also being dominated by foreclosures re-sales and first time buyers.  Some data on last month sales:

SoCal Data – October 2009:

Foreclosure re-sales –   40.6%

FHA Insured loans -         38.3%  (two years ago this number was 2 percent)

It is hard to extrapolate any normal market trends from this because the market is anything but normal.  We have HAMP trial mods and most are in California.  You can bet your money that the majority will not stay permanent and will add more inventory in 2010 once they fall out of HAMP (the government will probably make another program to modify failed HAMP mods called RE-HAMP).  The numbers are fluff on the front-end.  Expect this to hit at the same time as the recast wave.  As we now know, banks can game the system but that doesn’t mean that the market is going to boom or even stabilize.  Take for example the MLS inventory trend:

Since September of 2007, the MLS inventory has fallen dramatically.  Good news right?  Not exactly.  Because most of the inventory is now part of the shadow inventory.  Nearly half of all sales are foreclosure resales so many of these homes don’t even make the public list.  So we now have to adapt to the new reality of the market.  If you have any doubt about this, just take a look at recent distress data put out by TransUnion:

Over 10 percent of all California mortgage borrowers are 60+ days late!  This is uncharted territory.  Clearly there is little dispute that growing foreclosures is not a good thing.  California having the second largest average mortgage balance of $354,000 puts an enormous amount of money at risk.  How distressing is this data?  Let us break it down further:

California homes with a mortgage:           5,290,000

10 percent 60+ days late              =             529,000 homes

Current Seasonally Adjust Annual Rate of Home Sales    =            530,520

In other words, we have a year of distress inventory and who really knows where this is at.  Some of it is REO.  Some of it is in HAMP.  A lot of it is sitting pathetically idle in the balance sheet of banks in a form of toxic mortgage stalemate.  People aren’t paying and banks aren’t moving.  Everyone is now waiting for a bailout thanks to moral hazard central.  The only data where it shows up is in the distress data of the 60+ days late because it certainly isn’t showing up in the MLS.

Another chart showing the new reality of the California housing market is the monthly nut metric.  Don’t expect to find this in any economics books but this is another good measure of how much debt the current buyer is willing to take on:

At the peak, the typical California home buyer was willing to take on an insane $2,500 principal and interest charge.  Actually, this data is completely misleading because this was based on crazy mortgages including option ARMs which didn’t even include principal!  Or even all of the interest for that matter.  Now, with FHA insured loans being the bulk of the mortgage market people are committing to a typical payment of $1,196.  Try finding something that fits into that data in the Westside.  Of course the market is correcting.  But some people are obsessed with niche areas that they miss the larger trend.  I get the sense that some people want to buy a Beverly Hills mansion for $200,000.  Not going to happen.  Yet the reality based market is adjusting as the above data is showing.

Since people seem to forget why the market is taking such a big hit, let us take a trip down foreclosure alley.  Today we salute Compton, El Monte, and Downey with our Real Homes of Genius Award.

Foreclosure Alley

Our first home takes us to Compton California.  Compton has been devastated by the subprime mortgage fallout.  This home is no exception:

Ah yes!  The very common garbage can photography technique.  Banks are so motivated to move inventory that they don’t even bother to move trash bins out of the way to market the home.  I’m glad banks are trying to get the most bang for their taxpayer bailout buck.  The above home is a 2 bedroom and 1 bath home listed at 576 square feet.  Let us look at the sales history here:

This home is currently listed for sale at $54,400.  Lost decade for this home.  Can it reach the double lost decade figure?  A 74 percent price cut would make anything seem possible.  What do you think this home is going to do once it sells at a low price?  Lower comps.  The backlog of distress inventory assures us downward pressure on prices in future data measures.

Let us move on to home number two:

Are we buying a home or vegetation?  Thanks banks for taking the time to take quality pictures!  You were more than happy to make loans on these places and you can’t spend some time on taking a few quality shots?  Last time I checked eBay has some quality digital cameras for $200 or less.  I’m sure you can use some of the trillion in bailouts to purchase some decent photo equipment.  Just saying.  This home has an interesting history:

The homes is currently listed at $85,000.  A 1 bedroom and 1 bath home listed at 910 square feet.  Let us look at the ad description:

“Great opportunity for investor or owner/occupant. This property has great potential and is priced right for a quick sale. Surprisingly spacious with great utility. Requires significant repairs.”

You’d probably get $700 a month for this place as a rental.  Great investment right?  Well you need to factor in those “repairs” and also, many areas have higher vacancy rates because unemployment is sky high.  Many novice real estate investors right now are jumping in having no clue how volatile being a property manager can be.  They look at the rent, multiply it by 12 and subtract their principal and interest payment and suddenly it looks fantastic.  It isn’t that simple.  But hey, this is California housing math!  Why let little details get in the way like the 22 percent underemployment rate?

The third home takes us to El Monte:

This home is a 1 bedroom and 1 bath home listed at 760 square feet.  It looks bigger because of the yellow grass and the size of the lot.  But it might be hard sleeping on the lawn.  Feel sorry?  Let us look at some sales history:

The person who bought in 2005 just lucked out.  They lost some money but hey, not like the recent buyer.  The current list price is $206,900.  Keep in mind that $500,000 in many other parts of the country would buy you a castle like mansion and here, it gets you 760 square feet with yellow grass.  Real Home of Genius indeed.  Who is the next lucky buyer?

Our final home takes us to Downey:

This home is a 4 bedroom and 2 baths home.  It is listed at 1,372 square feet.   So what caused this home to go into foreclosure? Many reasons including the home equity machine:

Ah yes.  100 percent financing for a $517,000 home.  Of course, this didn’t end well.  Zero down for this place.  The ending is very common.  The current list price is $274,900.  Chalk one up to the California dream gone insane.

These are homes currently selling and we have thousands more.  What do you think is going to happen to median prices when they sell in their local areas?  Today we salute you Compton, El Monte, and Downey with our Real Homes of Genius Award.

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Real Homes of Genius: Today we Salute you Compton, El Monte, and Downey. Four Examples of Foreclosure Alley. The Hesitant California Housing Market.

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I’ve been reading about the tulip craze these last few weeks.  The parallels to our housing bubble are similar except that the housing bubble brought the global economy crashing to its knees.  Bubbles are nothing new and risk taking is as old as our first ancestors going out in the wilderness to chase prey.  It is easy to describe the economics of the housing bubble.  Easy credit fueled by our government and Wall Street allowed unqualified buyers to purchase homes beyond their means.  In economic terms we can understand why the bust occurred.  But what in the national psyche allowed for such rampant speculation to occur?  In many ways, the same fire that lit a match back in the Great Depression.  Many Americans felt it was their birthright not only to be rich, but to become extraordinarily rich through the road of speculation.

It wasn’t like over the decade, Americans suddenly became wealthier.  To the contrary, wages were stagnant over the decade.  Over the last three decades, Americans have become more and more immune to using credit (aka going into debt).  So when it came time to buying a $500,000 Real Home of Genius with no money down, this seemed like no big deal.  Every other infomercial during the housing boom talked about housing.  Cries of “no money down!” or “overnight millionaire” plastered the airwaves.  Even after the current bust, you will now find infomercials talking about profiting on the bust of the housing bubble!  This get rich quick idea is simply too alluring for many because in reality, the standard of living for many has gone down in real terms.  So why not leverage yourself into a leased BMW and McMansion even if it only lasts for a few years?  Like the Dutchman struggling just to survive in the 1630s, it must have sounded sweet that you can make 3, 5, or even 10 years worth of salary simply by trading tulips.

We had our champions of the housing boom.  Even our former President had this to say regarding homeownership:

“Part of being a secure America is to encourage homeownership.”

If it is put this way, it seems that homeownership is necessary like eating or breathing.  Even in the current administration, there is this idea that everyone should be given the chance to homeownership.  In fact, the reckless loans are now occurring with FHA insured loans.  The FHA is probably six months to a year from requiring a government bailout.  The fact of the matter is the housing gambling mentality is still strong.  Now you have many buying foreclosures thinking they can flip them for a tidy profit.  Who are people going to flip these homes to?  Many of the current buyers are first timers that are using near zero-down FHA insured loans on lower priced homes.  Looking for cash flow?  Rents are falling in California so you better hope you have some conservative projections.

This is the mentality that allowed the housing bubble to form and expand.  Let us now shift gears and look at some details of the California housing market.  The California Association of Realtors had a good report last month showing the details of the California housing market.  I’ll cover a few of the slides and try to put some of the current myths to rest.

California Housing Market – Dr. Jekyll and Mr. Hyde

The above chart should put the first myth to rest.  And that is, prices have recovered to the point of erasing some of the losses and are inching closer to their peaks.  The above chart clearly shows that most areas are near their troughs.  California as a state is still down by a stunning 50 percent from the peak.  We still have the Alt-A and option ARM products hitting major recasts between 2010 and 2012 so what is that going to do with the higher priced markets?  It won’t help in terms of getting closer to peak prices.

If we look at the details of the market, it becomes apparent that the action is at the lower-end:

This chart is probably the most telling.  In fact, this chart gives us the solution to the housing market riddle.  Prices need to fall!  You will never hear that from our government or Wall Street.  But this above chart shows that yes, the basics of demand and supply do work if you allow prices to reflect area fundamentals.  Sales have gone up as prices have come down.  Yet think of what all these bailouts are doing.  They are artificially keeping prices higher and spurring mini bubbles.  What you see above is a perfect example of the housing bubble fixing itself.  Yet the government and Wall Street (is there any difference at this point?) are trying to keep prices artificially high.

We are entering a new phase of the bubble.  FHA insured loans have now replaced Alt-A and option ARMs in the California housing market.  Remember, option ARMs are largely a California problem with 58% of loans here in the state.  Now why are FHA insured loans a problem?  People are financially stretching yet again with these loans.  They only require a 3.5 percent down payment.  Don’t think many in California are using these loans?

FHA insured loans are now a gigantic part of the California housing market.  And these loans resemble some of the low document loans that have caused so many problems.  Just look at the details of these loans:

What this tells you is a very important fact.  People in California are once again over stretching.  The median down payment on a FHA insured loan is 3.5% and people are going with the minimum!  This is no buffer at all.  Say home prices fall another modest 5 percent.  Then all their equity is wiped out:

$261,500         (home price)

-$9,888             (down payment)

$251,612         (mortgage)
Home prices fall by 5%:

Home value:     $248,425

Congratulations, you are now underwater by $3,187.  This might not seem like much but this is roughly 30 percent of the initial down payment.  Since FHA insured loans now make up 32 percent of the California housing market, this is only another problem that will hit down the road if the economy doesn’t improve.  And don’t think that $261,500 is a cheap price:

The California housing market is still over priced in many areas.  Keep in mind that some heavily distress areas like the Inland Empire may be closer to their bottom than say Orange County.  I know many in prime areas like to believe that they are immune for a variety of reasons but they are going to have to sit back.  The sales are occurring where prices make sense:

Even over the last data point, from July to August, a time where housing bulls are claming all is well, housing inventory has increased at the top end of the market.  The only market segment to improve is the sub-$300,000 market.  Do you think FHA insured loans have something to do with that?  And what is going to happen when the FHA is going to need to tighten lending standards after they go to the government for a bailout?  We all know this is going to happen.  Then what?  Are we all going to once again start buying tulips and grow them in our gardens for future down payments?

Some stats are a bit deceptive.  Take for example the below chart showing the percent of zero down buyers:

First of all, this might look like an improvement at first.  But I drew in the line of FHA buyers and the chart looks very similar.  3.5 percent down is nothing.  It provides no buffer to any short term falls.  Heck, you typically need two months worth of rent for leasing a place.  All it would take is another 5 percent decline and we have a new batch of underwater California homeowners.  Do we really need that?  The number one factor in foreclosure is negative equity and here we are setting up over 32 percent of the market in this position.  We need at a minimum, a 10 percent down payment on any government backed loans.  Why?  Because this is how you can develop a system of giving loans to people that actually saved money for one, two, or even three years and showed some sort of discipline.  It also provides an inherent buffer to short-term fluctuations.

But the government and Wall Street know that people are still broke and therefore need to allow people to purchase homes at still inflated prices.  They want the bubble to inflate again but clearly prices are not moving because the balance sheet of many Americans has been harmed by a little thing called jobs.  So much focus has been given to housing, that the government now has to contend with a 17.5 percent underemployment rate nationwide and in California, it is up to 22 percent and here we are pumping out $250,000+ mortgages to people with 3.5% down!  Most of which is going to come back via the tax credit!  Can you hear that money flushing down the toilet?

The distress sale market is still the market in California:

Over 46 percent of all sales in 2009 were distress sales.  This without even having to contend with the Alt-A and option ARM wave that will hit in 2010 to 2012.  What the above charts show us is a very clear picture.  To sell homes and create a market, you need to lower prices.  Or, if you want to be risky, finance loans with low down payments.  People are willing to take out a million dollar loan if you let them.  This bubble proved that.  But it also proved that it ends badly for the economy when that happens.

In some areas, the amount of distress sales is incredible:

80 percent of sales in the Inland Empire were distressed sales!  Is it any wonder these areas have seen such enormous price declines?  But all areas have their large share of distress sales.  The notion that the market is now somehow healthy is false.  Each distressed sale causes a loss somewhere on the food chain:

Each distress sale costs about $100,000 for the seller, whoever that may be.  For conventional home sales, sellers are actually gaining about $85,000 but this is a smaller part of the market.  Again, you have to read into the data.  Say someone in Pasadena bought a home in 2000 for $250,000, at the peak it would have sold for $700,000, and now they fetch $450,000.  On paper, they’ve gained some $200,000.  A nice sum indeed but it misses the bigger picture.  By combining all the above factors it becomes clear that for California the large drivers for sales have been:

-Crashing prices

-FHA insured loans

-Investors buying distress properties

-People buying homes with conventional loans believing the bottom is in

Prices are still near their trough.  Why are we to believe that a spike in prices will create more sales?  The above shows us that there is a tale of two cities in California.  Yet most of the action is happening in the lower priced city.  The next question is whether the other city lowers its price because of the next wave of defaults.

I’ll end this post with another quote from TulipoMania:

“Compared to such insane wagers, tulips looked like a good investment.  Growing bulbs was a lot easier than working an eighty-hour week hammering horseshoes or working a loom, and because demand for the flowers was steadily increasing, prices, at least for the finer varieties, consistently rose.  No wonder Dutchmen thought they had chanced upon the dream of every gambler: a safe bet.”

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A Tale of Two California Housing Markets: The Financial Gambling Psychology and Exploring the Distress Housing Market. 10 Charts Examining the Volatile California Housing Market.

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The California housing market is slowly entering phase two with the Alt-A and option ARM train quickly barreling down the tracks.  Attorney General Jerry Brown should be hearing back from some of the top option ARM lenders soon since he put a November 23^rd deadline on his request for additional information.  This information should give us deeper insight in to what option ARM lenders have been doing to remedy the approaching tsunami.  It is likely that not much has been done.  Wells Fargo is attempting to remedy the issue by converting Pick-a-Pay loans to interest only loans.  It is yet to be seen how well this is going to workout or what other lenders are doing.

For all the recovery talk, housing is still seeing massive amounts of foreclosures.  On Thursday we saw the 8^th consecutive month of 300,000+ foreclosure filings:

In other words, homeowners are still losing homes at a record pace.  The stock market might like this but the vast majority of Americans must be wondering why a stock market is up 60 percent when foreclosures are sky high, unemployment is still increasing, and the U.S. dollar is on a progressive state downward.  The stock market is defying all rules of logic with high price to earnings ratios and ignoring market fundamentals.  Yet in the last two decades, economic fundamentals were after thoughts with two enormous bubbles in technology and housing.

FHA Going Broke

FHA loans were never intended to become a giant part of the mortgage market.  Don’t tell that to California.  Take for example last month’s data that shows for Southern California, 36 percent of all homes purchased were financed with FHA insured loans.  Since FHA only requires 3.5 percent down, FHA insured loans have replaced the Alt-A and option ARMs as the new leverage product for those with miniscule down payments.  Surely this move has done wonders for the FHA right?

“(WaPo) As of Sept. 30, those reserves had an estimated value of $3.6 billion, a sharp drop from the $12.9 billion available a year earlier, the audit found. The current total represents 0.53 percent of all outstanding single-family-home loans insured by the FHA, well below the 2 percent portion set by law. This is the first time reserves have fallen under that threshold since 1994.

A year ago, the agency’s reserves equaled 3 percent of those loans.”

Whoops.  It must be stunning to find out that making low down payment loans in a recession is resulting in higher defaults.  The only other examples we have of this are interest only loans, subprime, Alt-A, and option ARMs.  FHA was supposed to be different because they actually looked at W-2s?  Of course the FHA doesn’t envision a scenario that we all now find to be obvious:

“Under the audit’s base scenario, the FHA can cover projected losses over 30 years and have $3.6 billion left in its reserves if home prices stabilize by the second half of 2010 and start rising about three years later. The agency’s reserves could even bounce back to the required 2 percent level by the end of fiscal 2012, the audit said.

But under the audit’s most pessimistic assumptions, the reserves would run dry in fiscal 2011, requiring a $1.6 billion cash infusion from the Treasury. This case assumes that home mortgage interest rates would plummet to about 2 percent and trigger a significant wave of refinancing. It also assumes that most of those borrowers would refinance out of FHA-backed loans, depriving the agency of insurance premiums. FHA officials said that scenario is unlikely.”

The new strategy is more housing speculation!  Wells Fargo is speculating that all those interest only loans will be in the green in a few years and the FHA is thinking that things will turn around by the middle of next year.  I’m so glad that now instead of toxic mortgage lenders speculating on low down payment mortgages, we have the FHA playing this game.  I described in detail why housing will be in a long winter and much of it goes beyond short-term tweaks to the system.

Another bust for the housing market is the home equity machine phenomenon.  Never in our history have we seen so much money extracted from homes to fuel consumption.  People forget that many of the options ARMs have 2^nd mortgages attached to the home.  Some people did not buy during the bubble yet put themselves in financial danger by refinancing their home like a piggybank.  Today’s home is one of those examples.

Today we salute you Irvine with our Real Home of Genius Award.

The Irvine Home Equity Machine

Orange County has seen the median home price stabilize in 2009 yet this is based on higher priced homes selling at lower prices and the shift in home sales volume.  In fact, foreclosures are at an all time record high:

Source:  Matthew Padilla at the O.C. Register

Clearly the above isn’t good news.  Yet if look into the data we see that 1^st time homebuyers spurred by the tax credit and investors looking for quick gains are a large part of the current market.  Today’s home takes us to the city of Irvine.  This home is the perfect example of a home equity machine:

The above is a nice 3 bedroom and 2 baths home that is listed at 1,116 square feet.  This is what you would consider a starter home for a working professional couple.  The home is currently listed for sale at $420,000.  If we look at sales history we see the last recorded sale back in 2000 for $265,000:

Sale History:

9/22/2000:       $265,000

So this is a happy ending here right?  We have someone that bought the home for $265,000 and is looking to sell for $420,000.  They missed selling at the peak but that is okay.  Not a bad profit of $155,000 without factoring in sales commission or any additional costs.  But that is where the conventional side of the story ends.  California was home to the HELOC ATM machine.  This home was anything but conventional:

Welcome to the OC folks.  So a home purchased in 2000 for $265,000 by 2004 had:

First mortgage:  $315,000

Second mortgage:         $381,500

Yes, a second bigger than a first.  But the story didn’t end there.  In 2006 they took out a third mortgage with the Orange County Teachers Federal Credit Union for $119,100.  So in total by August of 2006 this home had $815,600 in loans!  And not once during the decade did this home sell aside from the 2000 purchase which makes this even more incredible.

And get this.  The Case-Shiller data when this home sells (if it sells above $265,000) will register a nice price gain.  Yet the reality is some lenders are going to eat some major losses here.  That is why it is important to look at all the factors involved here.

When talking to people that didn’t grow up in the U.S. about home equity refinancing they cannot believe something like this would happen.  It doesn’t compute that people were able to use their home finance vacations, cars, granite countertops, or gold plated toilets.  This was a very unique domestic issue.  Sure, many countries had major housing bubbles but very few have examples of home equity withdrawal machines like the above case in California.  And this is only one example of thousands.

Today we salute you Irvine with our Real Home of Genius Award.

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Real Home of Genius: Irvine California and the Home Equity Withdrawal Machine. FHA Approaching the Zero Bound.

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America has built a large part of its economy on homeownership.  Owning a home is part of the ever more elusive American Dream.  Yet over time, owning a home became a larger and larger burden as new buyers were required to take on bigger debt loads merely to buy a basic home.  Incomes weren’t rising so debt was the new subsidy.  The apex of the bubble was reached in 2005 although prices didn’t start falling in drastic fashion for a couple years later.  The U.S. Treasury and Federal Reserve are largely to blame for inciting the biggest housing bubble the world has come to know.  Wall Street is equally to blame for creating the structure that allowed this to happen as they championed de-regulation and completely neglected any fiscal responsibility.

In today’s article, I will dissect the housing market from every angle.  It is easy to get caught up in the day to day data but the bigger picture is usually missed.  Let us first look at the total number of housing units in the U.S.:

us housing units

In the United States we have approximately 129,000,000 housing units.  These are made up of owner-occupied, rented, and vacant units.  The largest of these three categories is the owner-occupied category and most of the media focuses on this number.  Yet the other categories carry as much weight in determining a housing recovery.  Let us look at the vacant housing units:

The vacancy rate for both owner-occupied and rental properties is still near all time highs.  With so many sales, how can it be that this number is so high?  I’ll get into this later in the article.  But part of this has to do with demographics, the makeup of current housing inventory, and years of over building.  It is also the case that we are shifting a large number of would be renters into homes and causing the rental vacancy rate to spike.  Many of these apartment projects are financed with commercial real estate loans and the Federal Reserve is essentially shifting defaults from residential loans to commercial loans.  That is why we are seeing rents fall as owners compete to fill vacant units.

So now we have the universe of housing units including vacant units.  Let us drill down and examine the number of owner-occupied homes and renter-occupied units:

75 million Americans own their home.  The homeownership rate is derived from only looking at occupied units.  That is why it is important to also keep in mind the vacant units sitting on the market.

You’ll notice that the ownership rate does not factor in the vacant units.  The vacancy rate is at historical highs and this is another factor that will drag on the housing market for years to come.  37 million Americans rent their housing.  This can be apartments or actual detached homes.  The number of renters has recently increased as homeownership has fallen:

The chart has a few patterns worth noting.  From 1985 to 1995 the homeownership rate in the U.S. hovered around 64 percent.  The only recession during this time was in the early 1990s yet the rate remained steady.  The first spike started after 1995.  This trend went from 1995 to 2000 and pushed the homeownership rate from 64 to above 67 percent.  Part of this had to do with the technology bubble and the growth in the economy.  But then we hit the early 2000s recession largely brought on by the burst of the technology bubble.  Instead of homeownership declining which is typical in recessions, the homeownership rate expanded upward.  Much of this was due to Federal Reserve Chairman Alan Greenspan dropping the Fed funds rate to record lows.  Wall Street looking for the new-new thing, went from tech IPOs to mortgage backed securities and the toxic mortgage party started.

This easy access to credit and excessive risk pushed the homeownership rate to nearly 70 percent in 2005.  But that was it.  The bubble burst and the homeownership rate is now on a steady decline.  While the above chart is moving lower, one chart is moving higher.  The U.S. home vacancy rate:

Rental properties always have higher vacancy rates merely by the nature of their use.  Someone renting a home is more likely to move than say someone who buys a home and plans to stay in their home for many years.  Yet the above chart shows an unmistakable pattern.  The rental vacancy rate from 1968 to 1984 hovered between 5 and 6 percent.  From 1985 to 1999, it was in a range of 6 to 8 percent.  And finally, from 2000 to our present situation it went from 8 percent to 10 percent.  This is historically as high as it has gone.  You will notice that the rental vacancy rate dipped after the peak in 2005 since many people opted for rental units instead of buying a home.  Yet the pattern is still holding steady.

Now looking at the homeowner vacancy rate shows another story.  Too much building.  From 1968 to 2004, the rate never crossed the 2 percent mark.  Now, we are closing in on 3 percent.  That rate may not be reached now that the market is shifting gears.  But if we do have another foreclosure wave, 3 percent is possible.  What happened here?  Too much building and ignoring demographic trends:

From 2001 to 2006 home building was off the charts.  Single-family housing starts were up to a seasonally adjusted rate of 1.8 million a year even though population growth did not warrant this amount of new inventory.  From 1999 to 2001 the rate was hovering around 1.2 million.  So 600,000 properties were being added each year above the normal trend and this lasted for 6 years.  Of course, this number has collapsed at a pace not seen since the Great Depression but why did it occur?  People ignored the trend and demographics:

The above data exemplifies the housing bubble.  Each year roughly 500,000 homes are destroyed for a variety of reasons.  This of course isn’t discussed in the mainstream media but it helps to figure out a more accurate figure of what is going on.  Most households will buy their first home in the 25 to 34 years age group creating a demand of 1.9 million homes.  We also have homes hitting the market because of the other side of the age equation.  We have 11.6 million households in the 65 to 74 age range and 9 million in the 75 to 84 age range.  Life trend dynamics (i.e,. death and downsizing) add 1.1 million units per year to the market.  In other words, here is the breakdown:

Now this data is using trends up to the end of 2008.  We were burning through 350,000 excess units per year at the end of 2008.  Of course, housing starts have now collapsed and are adding new units at an annual rate of 500,000 homes.  So a significant indicator of returning to a healthy market is more linked to the actual vacancy rate.  In fact, adding up the units we have about 3 million too many units on the market over historical trends.  Depending on our current burn rate, we have:

3 million / 350,000 = 8.5 years

3 million / 850,000 = 3.5 years

And this is the time it will take at current rates to get to a more normal market if there is such a thing.  Yet the 850,000 figure is too optimistic because we now have a new factor in the mix in the sales data.  Foreclosures:

For the past year, each month over 300,000 homes enter some stage of foreclosure.  This is either a notice of default, a scheduled auction, or a home going back to the bank as an REO.  This number actually increases the length of time before we reach a stable housing market.  As you can see from the chart above, the rate is still at a record.  Now why is this the case?  Think of the dynamics of a healthy market.  Those in the household formation age, sell a home and in many cases will buy a move up home.  This can be a new home or an existing home.  Either way, they are clearing some of the vacant inventory off the market with typically two transactions taking place (buy and sell).  With foreclosures, it is normally a one and done deal.  Someone loses their home, and the person buying that home is merely taking over inventory that has already been accounted for.  This is why looking at foreclosure figures is so important.  Even in 2006 foreclosures were elevated.  If you consider that year as normal, foreclosure starts should range around 100,000 per month.  We are solidly over 300,000.

We still have many more foreclosures coming down the pipeline with Alt-A and option ARMs hitting significant recast dates.  This will only make it harder for us to clear that massive amount of excess inventory just sitting on the market.  With nearly one-third of homes sold nationwide as foreclosure re-sales, the excess inventory is sure to linger for a very long time.  Take a look at existing home sale data:

I’m taking the non-seasonally adjusted rate because with historical foreclosure rates, looking at typical data really does little in answering the real question of where we are going.  In September 472,000 existing homes sold.  Add in about 40,000 new homes sold and you are looking at 512,000 total home sales.  However, in the same month 343,000 homes entered into some stage of foreclosure.  Forget the data on HAMP for the moment since the 650,000 or so pre-trial loan mods means very little, the actual cure rates are extremely low:

We’ll be optimistic and use the 6.6% figure.  That means, of those 343,000 foreclosure starts 321,000 units are going to be additional inventory.  So even with 512,000 homes minus the 321,000 added units, we are not burning off excess inventory in any significant number.  And that is why the vacancy rate is still jumping and homeownership rates are falling.

It also doesn’t help that mortgages are delinquent at a rate never before seen (aside from the Great Depression):

Over 9 percent of all mortgage holders are now delinquent on their mortgages.  Of the 75 million homeowners 51 million have mortgages.  So that means as things stand today, close to 5 million mortgage holders are delinquent on their loans.  Since we are not seeing this in the REO data, this must mean the following:

(a)  30+ days late and no notice of default

(b)  90+ days late and a notice of default (reflects in monthly foreclosure data) – or 90+ days late and no action at all

(c)  Auction scheduled

(d)  HAMP – 650,000 in pre-trial

Yet the cure rate is at 6 percent and this is for prime loans.  We know that we have Alt-A and option ARMs coming due in the next few months and none of these qualify for HAMP.  Wells Fargo announced that they are converting over $100 billion in Pick-A-Pay option ARMs to interest only loans but who really knows if this will even help.  Already for the option ARM universe, some 45% of option ARM borrowers are 30+ days late.

Conclusion

What can we gather from the above data?  Home prices are falling even though data in the short-term might state otherwise.  This is due to artificial inventory figures because of mortgage moratoriums and banks not moving on distressed homes in a typical fashion.  There is an enormous amount of overhang in the market.  Using typical measures the data doesn’t show up but does show up in shadow inventory data.  The reason home sales have increased recently is because prices have collapsed:

Why are we to assume that if prices go up, people will keep on buying?  The driving force right now is affordability brought on by:

-Large number of foreclosure re-sales (nationwide about one-third of all sales, in California it was up to 50 percent of all sales)

-Government programs including the $8,000 tax credit

-Federal Reserve buying GSE MBS – no one else is buying them

-Artificially lowering mortgage rates (hovering around 5% while 40 year average is closer to 9%)

With all the above, we are merely treading water.  What we can gather from the above is we have years to work through this.  Also, the growing number of baby boomers shifting into retirement will also add to the additional housing units at a higher pace since those in the 25 to 34 years of age group are no longer having families in large size.  Many may opt to rent for much longer since some are delaying having kids until later in life.  In other words, the trend is not conducive to the McMansion world.

There are many factors to consider in the current housing market and it is my hope that this article helps to show the bigger picture of what is going on.  This is how I learned to stop worrying and love the housing bubble.

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The Comprehensive State of the U.S. Housing Market: Learning to Love the Housing Data and Forgetting the Economic Facts. Everything you wanted to know about U.S. Housing Trends.

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