From Calculated Risk

DCB?

CALPERS, the California Public Retirement Pension fund is about to learn that lesson the hard way. Formed in the 30′s, but built on the back of the 50s through the 80′s, it’s investment options expanded from solely bonds to real estate, to equities.  During this time, America experienced the greatest growth of real estate, equity, and bond values.  But most of all, of leverage.  Sadly, most of the value “growth” in the US over the past 20 or so years has been attributed directly to monetary growth.  Indeed, as yields on lower risk returns shrink, perception of higher risk equity values go up.  Unfortunately, for many, this mirage has much more power, and this perception that trees grow to the sky and all charts go up and to the right meant that there was little risk in promising free healthcare and pensions to the moon for all who worked for the grand state of California.

Except that it can’t.  The high profile failure of CALPERS has been nothing short of stunning.  Having lost more than 30% of its total value in 2008, it is unclear how the future promises made to state employees can be filled.  Especially when those promises are built on expectations that returns are 7.75% over the long run.

SFGate recently reported that they are considering lowering their benchmark rate above.  As reported:

Larry Fink, CEO of the giant money management firm, BlackRock Inc., with which CalPERS has invested, told its board in July, “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”

Even that might be optimistic.  When mortgages were returning 10% and you could expect a 1% chargeoff ratio and a 1% management fee, you could maybe meet the goal with a moderate amount of leverage.  When mortgages are yielding sub 5% and chargeoffs and management fees eat up most of that, you’d have to create an insane amount of leverage, which only increases your risk, to make it even rationally feasible, if even possible.

Why is this important?  Well, the benchmark rate determines the contribution rates, both of members and the State Government.  This is only one of many elephants in the room in California that noone wants to talk about it.  At precisely the time when the state can least afford to spend even more money, it may be required to.  Which only makes the situation more dire.  State and local government employees in California (in many, but not all cases) already enjoy higher pay than their private enterprise counterparts.  In addition to that, they are afforded better health benefits, vacation packages, and generous pay packages and benefits upon retirement.  When the world has all but forgotten pensions, many state employees enjoy the grandaddy of them all, a defined benefit pension plan.

It even seems quaint to talk about it since few still understand the difference between the defined benefit and defined contribution pensions.  It will suffice to say that the defined benefit is almost always much, much better, and much, much more expensive.  It’s quaint because most people who are not state employees in California do not even have a significant 401K, much less a crappy pension.  This is nothing compared to the Cadillac pension plan that virtually ALL state employees get.

So, to sum it up, California faces a budget shortfall of epic proportions.  It has parlayed every non-GAAP accounting trick in the book to delay the day of reckoning, hoping that pink ponies save them, but they have not.  The bill is quickly coming due, and indeed, the state may have even more troubles.  There is no way out.  Without serious pension reform (hand their asses back to them), taxes will have to be raised.  Given that the state already recalled one governor over licensing fees, I see this one going over like a lead balloon.  Meg Whitman has been campaigning that she can fix this mess.  I’m sorry, but there is nothing that will fix that mess except for a miracle or much higher taxes.  This still will need to invent something seriously out of this world to make that happen, or bite down on the bullet of austerity to balance the budget and maybe put something away for a rainy day (if it gets any rainier, this place is going to figuratively float away).

We need another investment bubble.  Luckily, the goldrush of 1849 proves that there is significant gold in them thar hills.  Perhaps we can put a tax on pickaxes and heavy machinery that will help us cover some of the shortfall.  With the bubbly prices that gold is now fetching, it might just do the trick.  However, I wouldn’t expect the Marijuana tax proposed earlier to make a big dent.  We’d need some serious potheads to move here to make it work (and they’d have to be stinkin’ rich to boot).

No, perhaps we we all need to collectively do as Californian’s is to do what CALPERS will in the end be forced to do.  Lower our expectations.  But, when have you ever known Californians to do that?

Bernanke should have just let the suckers fail and mopped up the mess. Our banking system would be better off if he had.

Can anyone here excuse this?  Doesn’t anyone else see a problem with the government pressuring private enterprise to do what they want them to do?

Is anyone really believing this shite?

Faced with sluggish progress in its foreclosure-prevention effort, the Obama administration will spend the coming weeks cracking down on mortgage companies that aren’t doing enough to help borrowers at risk of losing their homes.

Treasury Department officials said Monday they will step up pressure on the 71 companies participating in the government’s $75 billion effort to stem the foreclosure crisis. The will start this week by sending three person “SWAT teams” to monitor the eight largest companies’ work and requesting twice-daily reports on their progress.

This reads straight out of an SS playbook.  Fascism has a singular face, and it is bullying and intimidation!  That’s change we can believe in.

If you waited to buy a house because it was too expensive, ask yourself, is it too expensive now?  This is the easiest concern to get over.  In the throes of the housing bubble, you would have been told by your agent that you should just lower your expectations.  Buy a smaller place.  Buy a place further out.  Buy a place you don’t want, but can afford.  I’ll dispel any myths, there is no such thing as a crystal ball.  Just as I tell you that scamsters like Gary Watts didn’t know was going to happen, we also only operated on verifiable information.  All information is telling us that while a bit of affordability has returned, the underlying problems with the housing market still exist.  Let’s outline those quickly:

1.  Housing exceeds healthy income limits for much of Southern California (inland areas are back to a healthy level, so this really only refers to coastal areas, and some pockets throughout.

2.  Interest rates are low, masking the affordability problems mentioned above.  Rates are low because the Federal Reserve is intentionally targeting mortgage rates by purchasing up to 50% of all issued mortgage paper.  This is only intended to be temporary, and at some point, not only will this be removed, the current leverage must be unwound.  It is likely that interest rates will proceed higher.  While noone can know for sure when this will be done, it is likely to have an impact in the 2nd half of 2010 and into 2011.

3.  Unemployment in Southern California is increasing.  This is a known fact, and is expected to peak sometime in 2010 if things immediately improve.  However, it is expected that the decline will be less than steep, and high unemployment could persist for up to 5  more years after the recession ends.  Add in that California has become a very difficult place for many businesses to continue due to high taxes and infrastructure problems, and many companies are looking at alternatives if they upstaff.  Only lower wages will attract them back.  Lower wages do not increase home prices.

4.  The option-arm Tsunami has not come yet.  With an expected default rate that is much higher than subprime, and a concentration in coastal California, much of pain that inland areas sufferend is expected to occur in the more expensive areas.  If this materializes, buyers today are “catching the falling knife”.  The option arm recasts are expected to peak starting this quarter and cresting late 2010 and not declining until 2011 or 2012.

5.  The move-up market is dead.  The most starkly different part of this bust versus prior busts is that many, many people over-leveraged their houses even more than their increase in value.  Indeed, so many people are underwater at prices that locals can afford that it’s impossible for the majority of home buyers to move up at all.  This is one of the reasons that the low end is the most active areas.  Higher areas are simply over-priced for locals who fear for their jobs and have suffered a calamitous stock market setback.

6.  The banking system is unhealthy.  Leverage, and indeed money supply is decreasing.  This is the backside of a debt-fueled overcapacity bubble.  First, it was businesses that were overleveraged.  Then it was households.  Soon, it will be government, and there won’t be enough income to support the levels of debt and still account for imperfections in the system.  Someday, we’ll worry about

So, if you’re still interested in buying after knowing all of that, don’t say nobody warned you.  I understand, sometimes the social peer pressures push us to do irrational things.  Just look back at the bubble.  And, with the seemingly invincible Federal Government pulling out all stops to stimulate housing sales and ownership, it might seem that you just want to throw in the towel and give it up.  I know, I’ve wondered if it’s worth the wait.  I won’t think bad of anybody who buys now.

However, if you’re waiting for prices to come down more, I believe they will, but don’t fool yourself, no one will intentionally catch the bottom.  I don’t believe we’ll see the bottom until noone cares anymore, that’s how bubbles work historically.  We are, however, still pulling demand from the future.  We’ll overshoot by that much, at some point.  It can be fast and painful, or it can be slow and painful.  Either way, we haven’t had pain in the coastal areas yet.

Besides, if you’re wanting people to think you’re a genius, you might be surprised to find that no one likes the smartest guy in the room.  I know a lot of Goldman Sachs employees are finding that out.

Consider the above video in light of Chris Whalen’s post today at The Big Picture: Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On

There are some thoughts that Chris presents that are of utmost interest here:

Plain fact is that the Fed and Treasury spent all the available liquidity propping up Wall Street’s toxic asset waste pile and the banks that created it, so now Main Street employers and private investors, and the relatively smaller banks that support them both, must go begging for capital and liquidity in a market where government is the only player left. The notion that the Fed can even contemplate reversing the massive bailout for the OTC markets, this to restore normalcy to the monetary models that supposedly inform the central bank’s deliberations, is ridiculous in view of the capital shortfall in the banking sector and the private sector economy more generally.

…

Perhaps there is revisionist thinking at the Fed at long last, but not nearly soon enough to do anything about the impending implosion of the US banking sector in 2010. The significant point to us is not the cost to the FDIC insurance fund implied by the rising Bank Stress Index score, a cost which the banking industry will absorb and repay. But the real point is the permanent diminution of economic activity in local communities caused when good community and regional banks die due to the end-result of bad fiscal and regulatory policies in Washington.

There are a boat load of smaller banks that are being put into crisis through the crowding out effect of government influence with heavy-handed intervention.  Sooner or later, either the propped up banks be allowed to fail, or they will cause many more smaller banks to fail.  Which would you rather have?

Do you agree with Davidowitz?

Seems pretty bleak to me too. I’m trying hard to be an optimist, but it doesn’t seem like anything has improved, only gotten worse. In fact, California is now showing a 11.9% unemployment rate.

Even the supposed venerable and indestructible Los Angeles has an 11.6% rate and bulletproof Orange County has 9.2%. Those are all depression-era numbers when factoring in the

There seem to be some myths circulating both in the Financial Media as well as the blogosphere about exactly how long housing busts tend to last.  To clarify some of these myths, I’ll borrow heavily from 2 of the best know (and contemporary) housing busts, the Southern California 1990′s housing bubble and bust and some from the Japanese housing bubble and bust.

These myths are some that have cropped up at reputable financial media sites and on television often (I believe) because the human attention span is very short.  We find it difficult to believe that bad times can persist for a long period of time.  We have a coping method that tends to follow a predefined path, often known as the Kübler-Ross Model or Stages of Grief.  Over a period of time, we pass through Denial, Anger, Bargaining, Depression, and finally Acceptance.  However, keep in mind that just because humans have gotten over the financial tragedy of the 2000′s (which we haven’t), there is no specific reason why that should translate into a financial or economic end to the problems.  The real world operates outside of our internalized emotions.

Still, these myths are strong emotional pulls that if believed, will lead you astray.  Over the coming week or 2 I will be taking a guided tour through some of the strongest myths that have gripped the housing market.  Let’s start with the most pressing one right away:

Myth #1.  As soon as the recession ends, housing will jump right back up.

This myth plays on the fear that was found to be prevalent during the housing bubble.  It plays on the “buy now or be priced out forever” fear of being left behind.  Indeed, one could argue that immediately after the 2000 recession, housing prices quickly vaulted to the stratosphere and left many high and dry.  If this were to happen again, all those currently sitting on the sidelines would once again be left in the dust as many others partake in the new propserity of housing wealth.

However, keep in mind that the 2001 recession was not housing led like the July 1990 recession.  While both were quite short, they were very different.  In Southern California, the effects of the 1990 recession were felt long after it ended in March 1991.  Indeed, housing prices had been inflated to bubblicious prices as early as 1989.  As the economy strained under high housing prices, both consumption fell as well as pulled a number of financial institutions with it.  Albeit much smaller than the present crisis, the Savings & Loan crisis still strikes fear into the hearts of many bankers.  That was supposed to be “the big one”, and yet, it appears nothing was learned by that experience about residential prices risk taking.  This crisis played out much like the previous crisis, where defaults led to restricted credit which in turn hurt businesses.  Households strained under the increased debt load that had been created during the housing bubble in the previous 5 years, and that final crack shattered the weakest financial institutions.  The effect snowballed into a full blown crisis, requiring the formation of the Resolution Trust Corporation, or RTC.  The RTC did what the banks could not, liquidate assets in a timely manner.  This quick liquidation set the stage for a much stronger rally later in the decade and avoided a Japan-style housing bust where banks hold bad assets for fear of becoming insolvent and being remanded into recievership unwillingly.

First off, let’s clearly define how long housing prices fell during the 1990′s following the late 80′s bubble.  The following graph is inflation adjusted to 2008 prices, but the amount is not as important as the trip that was taken:

Source: Dataquick and BLS

As the readers can easily see, the 1990′s bubble was retraced in nearly every single major SoCal county.  Orange County, for example did not complete a full retrace as it developed from a sleepy surfing and vacation town into a pricey suburb of the LA area.  However, for most counties, there was a full retracement to the pre-bubble inflation-indexed prices.

There are some notable trends that one can see in the numbers.  First, that falls were fairly mild, so there was a transitory period for homeowners who had accumulated significant wealth through paying down mortgages and through inflation could still “get out” before the door closed.  This is important to the swiftness and the after-effects of the housing bust because it differs significantly with the existing housing bust.  Indeed, so slight was this housing bust, that many believed we would fare the same this time around (allowing inflation to eat away at the home prices makes them an economically bad decision, but not necessarily a bad financial decision if the price is right and the tax benefits are right as well).  With prices clearly more than 20% off in all counties this time around, a recession that it likely to be almost 3X as long as the 1990′s and with reckless speculation not seen since the 1920′s, a “soft landing” was never in the cards.  This the hardest landing we will have in our lifetimes.  Make no mistake about it, this will not be easily forgotten like the last bubble.

The next notable trend that one finds is that even after the recession ends in March 1991, housing prices continue to fall for 5 additional years until 1996.  This was primarily because several of the savings and loans tried to time the market, waiting for a rebound.  Only to find that their hesitation caused them to miss higher prices, eventually dumping them later as regulators forced them to liquidate into a softer market.  In a housing bust, there is no orderly decline, if we have learned one thing from prior busts, it is this: the longer you wait to foreclose and liquidate the property, the greater the economic loss and the more significant the effect to the financial institution.  In fact, so ingrained in the minds of market participants that housing was a risky investment that the greater masses shunned it for some time afterwards, only beginning to buy again when the argument was much more compelling than renting.  When buying was cheaper than renting, even accounting for potential losses.  We have not yet reached that point, as any further declines wipes out significant equity since in most places in Southern California, renting is still a significantly cheaper option after factoring tax consequences for most locals.

To give you a breath of where we have come so far, the following is the Southern California Housing Prices inflation adjusted for 2008:

Source: Dataquick and BLS

You can see that there has been no transition time for owners to jettison out the escape hatch.  While this is primarily a problem to do with mix (very low priced properties selling vs a normal mix), I will explore this more in detail in a future myth review.  Please note that even with the dramatic drop in prices, we have not seen a full retracement.  With the magnitude of the present bubble in perspective, I find it unlikely that at present course and speed we will simply give up at a retracement to prior fundamentals.  I fully expect an overshoot of epic proportions as the bubble that preceeded it was of epic proportions.  Here’s a chart showing the 2 bubbles side by side, adjusted for inflation:

Source: Dataquick and BLS

Finally, it is important to remember that when housing does bottom, it does not turn on a dime.  It is much like a vast oil tanker that requires significant time and distance to change course.  Ingrained social opinions are slow to change, but once they do, they don’t flip flop back.  We saw this in the Wile E. Coyote moments of 2007-2008 in our present bubble.  This recession is going to be significantly longer, and the recovery substantially slower than previous ones.  Indeed, the “truth about jobs” is that there may be many fewer than before because we are no longer driven by a significant bubble in Southern California (at least in the forseeable future) while the late 1990′s recieved a shot in the arm.

Some thoughts about the current unemployment rate (which is over 10% in California at the present time) and future projections over the next 2 years.

Indeed, remember that in past recessions, unemployment peaked some time after the recession ended, hence the effects of the recession being felt much longer than the recession lasting.  It is important to remember that the end of a recession only signals that the economy has stopped contracting.  It does not mean that there will be a quick return to the heady days of the prosperous times that preceded it.  This time might be much worse, as household balance sheets are still carrying considerable debt with litle savings.  Until those are rectified, it is hard to see any meaningful reignition of economic activity that is not inflation-linked.  And, with joblessness at record levels, any inflation we do see will not be the kind of inflation we saw in the 1970′s, constituting a wage-price spiral.

We’ll touch on that next time when we discuss Myth #2, Housing Prices will jump as soon as unemployment begins to come down.

Yes, the SCREBC-famous Pepto Bismol House in San Clemente.

My assertion at the time was that there were several problems in order of increasing stupidity:

1.  Terrible Marketing, pictures, etc.

2.  Terrible Pricing… one year on the market, chasing it down and never being close enough to reality

3.  Terrible Location.  I’ll let the picture speak for itself:

Well, if you wondered what happened… it’s back up for sale.

Yes, a scant nearly 2 1/2 years on the market hasn’t deterred this delusional seller from trying to sell for higher than market prices.  It’s listed today for 649K, probably a full 150K higher than what it would take to move the property.  At least they came down from 875K in December 2006.  If they had been aggressive then, I believe they could easily have gotten 750K to 775K at the time.  Unfortunately, greed got the better of the owner, the listing agent, or both.

The post is a “What Not to Wear” for home listings.  And, remember in September 2007 when the bubble was still a debateable topic?  Yeah, I warned the sellers then that the next year was going to be tough.  It was.

And, it doesn’t seem to be getting any easier.  Keep in mind that one of the properties that I compared it to last time seems to have been foreclosed on and appears to presently be in shadow inventory land.  It (a 2700sq ft sfr built in 2001 with much better curb appeal) appears to have gone back to the bank in January at $568.5K.  That doesn’t bode well for the area.

Besides, I think the realtor must not have changed or learned much in the intervening 2 years about property marketing:

I think she learned to turn the camera on its side this time… projects height.

Luckily, the buyer bought in 2000 for $402K.  They’re almost assured a gain on the house unless they already spent it.  Let’s hope they didn’t.  If this doesn’t sell, it’ll always be shadow inventory, waiting for prices to tick back up.  Unfortunately, there are many better prices in the area this time around.  Even though the listing is now 225K lighter, I’m afraid it’s still in fantasy land.

Thanks and come again to Fantasy Island.

We need the insanity to stop.  Stop rewarding bad behavior, let the country be fixed.

The systemic risk is that since credit = debt = money, we can pretend that there is more of it than is possible. That is because debt cannot exceed some fraction of the potential future amount of work. When it approaches that point, confidence collapses and the debt is destroyed. We have gone through this over and over and over in history. The hot fad now is to think government can alter this cycle by creating even more debt. The answer to that is : ha ha ha ha. Think it over: by preventing the destruction and extending the time frame of debt (by financing with future deficits) the government lengthens the process, as it did in the 1930s, rather than decreases it.
We are in for a loooonnnnnnnng one this time.

That is why we are just fiddling while Rome burns.  Twist from Housing Doom had it right: what we need right now to fix the housing market is MORE Foreclosures, not LESS.

Ladies and gentlemen,

Unfortunately, we have so far failed to comprehend the true scale of the ongoing crisis. But one thing is obvious: the extent of the recession and its scale will largely depend on specific high-precision measures, due to be charted by governments and business communities and on our coordinated and professional efforts. In our opinion, we must first atone for the past and open our cards, so to speak. This means we must assess the real situation and write off all hopeless debts and “bad” assets. True, this will be an extremely painful and unpleasant process. Far from everyone can accept such measures, fearing for their capitalisation, bonuses or reputation. However, we would “conserve” and prolong the crisis, unless we clean up our balance sheets. I believe financial authorities must work out the required mechanism for writing off debts that corresponds to today’s needs. Second. Apart from cleaning up our balance sheets, it is high time we got rid of virtual money, exaggerated reports and dubious ratings. We must not harbour any illusions while assessing the state of the global economy and the real corporate standing, even if such assessments are made by major auditors and analysts.

In effect, our proposal implies that the audit, accounting and ratings system reform must be based on a reversion to the fundamental asset value concept. In other words, assessments of each individual business must be based on its ability to generate added value, rather than on subjective concepts. In our opinion, the economy of the future must become an economy of real values. How to achieve this is not so clear-cut. Let us think about it together.

Third. Excessive dependence on a single reserve currency is dangerous for the global economy. Consequently, it would be sensible to encourage the objective process of creating several strong reserve currencies in the future. It is high time we launched a detailed discussion of methods to facilitate a smooth and irreversible switchover to the new model.

Fourth. Most nations convert their international reserves into foreign currencies and must therefore be convinced that they are reliable. Those issuing reserve and accounting currencies are objectively interested in their use by other states. This highlights mutual interests and interdependence. Consequently, it is important that reserve currency issuers must implement more open monetary policies. Moreover, these nations must pledge to abide by internationally recognised rules of macroeconomic and financial discipline. In our opinion, this demand is not excessive. At the same time, the global financial system is not the only element in need of reforms. We are facing a much broader range of problems. This means that a system based on cooperation between several major centres must replace the obsolete unipolar world concept. We must strengthen the system of global regulators based on international law and a system of multilateral agreements in order to prevent chaos and unpredictability in such a multipolar world. Consequently, it is very important that we reassess the role of leading international organisations and institutions.

If only we could have this kind of leadership in this country.  I was convinced that Obama would not simply revert to politics as usual, and my hopes have been severly dashed.  We are screwed up more than I thought.  You cannot fix free markets with state intervention; our speaker will attest to that.

Is now a good time to buy a new home? i would be a first time home buyer and i have heard the market is bad.?

Darren gave a long-winded answer:

Congratulations of thinking of buying a new home.

Is there a “bubble”? The simple answer is “no”. Even if interest rates move a bit higher, it won’t be enough to cause a nationwide slide in home prices. The key to a healthy housing market is the job market. If the payment on a new home might be slightly higher due to increased interest rates, it generally won’t stop someone from purchasing the home of their dreams…but if they feel their job is in jeopardy, it might be enough to stop them from making a move. So with the currently low levels of unemployment and the beefy gains in job creations, it looks like the housing market will remain vibrant. Although it will be difficult to sustain the double-digit gains that much of the country has seen, price declines are highly unlikely. Expect a more moderate rate of appreciation, perhaps closer to the historical 6-7% range, which is still very good.

The post goes on for nearly 2 more pages of bubblespeak.  It’s an interesting read on what was going on at the time.   The most choice example:

Don’t be victimized by the bubble hype. Buying a home is a big step, but it is almost always one in the right direction.

Darren was also quoted on housing doom and felt required to issue a long-winded discussion of the merits of buying a house, leveraging it to the hilt and other such nonsense.  I also at the time replied (when I was writing under the pseudonym John Doe) to his crazy thoughts:

I kinda wish we had a behind the music rendition of where is he now?

Anything worth saying to Darren after the bubble popped?

Therefore, I ask the most difficult question regarding the property that OCR dragged up in San Diego:

San Diego Shack

In this corner, we have the lightweight contender.  Weighing in at just 570 square feet, and surrounded by squalor, you can bask in the beauty of your red front door that leaves nothing to the imagination and your K-mart clearance special patio set.  Luckily for you, you can now dry your clothes directly outside your front door with the convenient ledger board that is stapled to the outside of your quaint demi-cottage.  Only you and your neighbor will know when you pass gas in this  beautiful little near-beach house.  IT HAS PRACTIALLY EVERYTHING YOU NEED TO SURVIVE.

Similarly, I’ll compare it to this:

Laguna Niguel Shack

This quaint beach cottage has a measly 10,000 square feet, but who can be sure?  It features subterranean parking, wine cellars, an opulent entry, is centrally located in Laguna Niguel near Monarch Beach and boasts a true 180 degree view of the ocean.  Luckily, you won’t need to hang your clothes out to dry, you actually have a laundry room and servants quarters to ensure your underwear is neatly pressed day or night.

However, there’s something this house lacks that the San Diego house has.  It’s a critical component in today’s current economy.

No, it’s not irrational exuberance… but you’re getting close.

Figured it out yet?

OK

Here

it

is.

The shack in San Diego boasts a higher price tag per square foot, exceeding $1000/ square foot while the opulent mansion with views to the ends of the earth weighs in at a measly $975/ sqft.

Now that’s amore.

Our friend, let’s call him Boomer for short, had this to ask of me:

Moved my family to La Costa area (renting) and own a house in AZ which I owe $159k at 6.5% (it adjusted and will again in 8 months) The home was at peak worth $750k now $550k I had it rented last yr for $2200 and just signed a 3 yr lease w/ new tennant for $2,400 . I have $600k in cash..Should I pay this house off?? or should I just refi it and hold on to my cash to buy here in S cal in a yr or two?

First off, I have a couple of thoughts:

1. Whoever Boomer is, he’s in a pretty good position, relatively speaking

2. Without knowing his age, I’d say Boomer is likely Early Xer or Late Boomer.

3. The most important point of all (where he wants or needs to live) is missing from the question. Don’t feel bad, many people forget this little factoid. We’ll assume that he wants to stay in SoCal.

I’ll deal with some important points:

1. What is that house in Arizona really worth long-term?

2. What should Boomer do with the cash?

3. What kind of financing makes the most sense?

What is that house in AZ really worth?

This is the question that wasn’t really asked, but needs to be answered, what is the house in Arizona worth, so we can understand what to do with the money.

Well, Arizona is a big place. It has a varied geography with beautiful vistas, scorching deserts, and some bone chilling mountains. You may not like what I have to say, but I’ll say it anyway. Your perception of the world and finances is the boiled frog syndrome. Not that I blame you. You’ve been raised in a world of ever decreasing interest rates and increasing asset values. The world has been kind to you.

You see, the success of many of the past 30 years (primarily the boomer cohort) is a demographic abnormality. Asset values have increased simply because of the organic demand of the Baby Boomer generation and ever increasing ability to finance that demand. In addition to this, an extremely relaxed monetary policy has increased the value of assets consistently since inflation was trounced back in the late 70s.

Unfortunately for many, that time is over.

In the short run, houses are worth what someone else is willing to pay for it, but in the long run, they are subject to the value of the next best alternative, or substitute pricing. The best substitute for owning a house is renting one. In some cases (such as short-term living), renting is almost always the clear alternative.

There are many formulas for determining the value, but one of the simplest mechanisms is the GRM (Gross Rental Multiplier). Basically, this number is used to multiply the monthly rent to arrive at a fair estimate of rental value. However, this is only a rule of thumb and is not to be taken as gospel; lower interest rates (like I expect we will see for the forseeable future) will increase the GRM, while substitutes (buildable land, locus to employment centers) will decrease it. In certain premium places like Orange County, the upper stretch might be 220 or so, while in places like Las Vegas or Arizona, a more reasonable 120 to 160 is more in line with reality. If we err on the side of optimism (150 GRM), this places the current value based on long-term fundamentals at about $360,000, leaving Boomer with a $190,000 premium over its fair value. If I were evaluating a stock, I’d say SELL! SELL! SELL! Doubly more so if Boomer had lived in the house for more than 2 of the last 5 years since he can walk away with pretty much all of the money tax free. It doesn’t matter what the market is selling at, if there is really that much of a disparity, sell that house and get your money! (of course, it doesn’t help that it was just rented, but there are always ways to let a renter go, if the price is right). At a 229 GRM, his house is badly overpriced. When it was $750K, I haven’t a clue how someone could justify that, since it would have been a GRM of 340. Holy smokes!

The future good in some ways, but bleak in other. The Southwest is largely overbuilt in nearly every city with a real dearth of extensive employment opportunities (unless WalMart is your target), and if energy prices remain elevated (not a given in my mind), the ability to pay will deteriorate along with the economy. Boomer may end up with late (or no) payments from his rental. Rentals are generally difficult to manage from a long distance and I would only advise it if you were planning on returning back to the home at some date. However, that would be hard after living in LaCosta for a few years.

In addition, a house can be valued at the cost of money to purchase it. This is a bit more detailed, but an easy rule of thumb is to take the rental equivalent, figure in future increases in rent, and discount the cash flows based on current borrowing rates. It accomplishes about the same thing as GRM, but removes the variability of borrowing rates (especially if it is held as a long-term investment). Using the inverse calculation, you could figure what the “money rent” on the current place would be given a few variables such as the “current value” and current interest rates. Given a current value of $550,000, the money rent valuation using 7% says that Boomer should be collecting about $3,700 in rent on that money. This leaves out taxes, repairs, rental expenses, vacancy, and many other options, so it is by far the most optimistic. By this reckoning, the house would have an imputed value of $357K, pretty darn close to our above $360K value. Sounds like time to sell this puppy no matter how you look at it.

As another way of thinking of it, as interest rates go down, this increases the ability to pay, but that can only increase so much since the risk of buying on low interest rates and being unable to sell into a similar situation will weigh heavily on others’ minds and prices will need to adjust to handle this uncertainty. Since demand for housing is waning as the boomer generation ages in place or downsizes (or simply dies), it is unlikely that houses will be able to continue their rich valuation long into the future without a substantial demographic to replace them with the ability to purchase.

Any way you look at it, the house is currently valued at more than it is “worth”. I can show houses in Orange County that currently have better GRMs than what this house is showing, and Orange County is one of the most overpriced locales in the US.

Tomorrow, I’ll deal with the question of what Boomer should do with his cash. Any thoughts before then?

What does he blame it on?  Banks.  Duh.  Isn’t that what everyone else is blaming it on?

OK, even in a way, I blame the banks too, but that doesn’t excuse the absolute unbelievable disregard for history, facts, trends, or truth.  However, I will extend an olive branch to Gary:  on one condition.  The condition is that I can get some of his speaking engagements (or at least as a ride along).  I figure that if the real estate industry is so brain dead that it can not only believe his past published crap, but buy it hook line and sinker, I have nothing to lose, and a whole lot of speaking fees to gain.

Some choice quotes from Lansner’s bag:

“I apologize for not knowing what Wall Street did to our mortgages,” Watts told about 360 attendees during the associations annual membership meeting at the Irvine Marriott. “I had no idea how Wall Street restructured these loans.”

No accounting for affordability?  No accounting for sales volume preceding price?   No memory of the written lashings he received publicly on blogs?  Does he have no memory of this?

Didn’t I write some verbal poundings here on this blog?  If searching Gary Watts on Google, my articles and sites linking to my articles were consistently on page 1 in the searches.  Did he really not know what was said about him?

What else?

Watts said today, however, that the tide of foreclosures likely will mean that the housing market will remain soft into 2009. He noted that short sales, or sales with asking prices below the owner’s mortgage balance, are taking at least six weeks to gain approval from lenders, forcing even more homeowners into foreclosure.

“It’s just inevitable that (foreclosures are) going to spill into the 2009 market,” he said. While a rebound still is possible this year, Watts said, he called the market too difficult to predict.

This is one thing that I am agreeing with him on.  The market is in such a disarray that it’s nearly impossible to predict what will happen through 2009.

Despite what the bottom callers are now saying, they are forgetting the achilles heel of housing.  It goes like this:

1.  Banks cannot hold nonperforming assets on their balance sheet.  Regulators will not allow it.  Bond covenants of RMBSs will not allow it.  Noone can hold onto REO property for very long.  They will price it to move, and if it doesn’t move, they’ll cut until it does.
2.  A  recession is a terrible time to sell houses, especially in bulk, or if you have to as above.  Buyers need to be assured they are getting a good deal before they are sure.

3.  Increasing numbers of NODs and NOTs ensures a parabolic supply of future REOs coming on the market for at least another 10 months, possibly as much as 36 months for Orange County because of the impending neg-am crisis about to unfold in 2009 and 2010.

4.  Whatever buyers there are today are still just setting bargaining points for future buyers.  The demographics of the situation does not allow it to be the bottom at this point.

5.  Voila!  The longer to wait will ensure lower prices.  This will likely be the case for the rest of the decade.  We’ll refresh predictions in 6 months.

I’ll part with an analysis of Gary’s assessment:

He also believes that subprime lending gets a bum rap for causing the housing slump. Rising subprime delinquencies merely acted as a catalyst, tipping a range of bundled “structured investment vehicles” into increasing trouble that alarmed Wall Street investors.

“It was so complicated. It’s a nightmare. A real estate credit crunch usually lasts six months, and this one, we’re in it almost a year, and it’s still not straightened out,” Watts said.

Jeebus, this guy is just reams of material.  It wasn’t, and isn’t just subprime.  It’s everything and I’m pretty sure he’s referring to MBS, not SIVs.  Credit crunches have been fairly uncommon, the last one of a similar magnitude in US history might have been the one directly preceding the 1930′s Great Depression.  And, those kinds of credit crunches take years to recover from the immediate effects, but the long-term effects were felt for more than a generation.  It’s likely that Gary Watts will be worm food before we see reckless abandon in lending like that again.  (at least I hope for the sake of all fiat currencies everywhere).

1. The bubble will or will not burst depending on your definition:

Predictions:

Sales Price: Down 5-7% correction

Sales Volume: Down 10 to 20%

Actuals:

Sales price: Down 13.3%

Sales Volume: Down 45.3%

Comments:

I whiffed this one. I believed strongly that we could encounter a credit event at some point in 2007, but as all events are, they are hard to anticipate exactly how swift they will start or end especially a year in advance. I was way too optimistic in 2007, though not nearly as optimistic as Gary Watts who predicted a 7% increase in prices.

I think that no matter whose definition you are using, the bubble burst in 2007. Only Gary Watts can’t see it, and he’s got to be the only person in the entire world who cannot see it.

2. The Subprime Mortgage market will shrink considerably.

Volume Prediction: Down 40%

Volume Actual: It has been difficult to find a reliable source that can be quoted, as even the MBIA doesn’t have a grasp on what happened in 2007 yet, it is safe to say that subprime was likely much more than 40% off from 2006. Many of the major subprime companies went Tango Uniform this year, while those that (somewhat) survived have been castrated (Countrywide total volume was halved, subprime near nonexistence)

Comments:

This again was unpredictable due to the sheer volume and speed of failures of subprime lenders. It is very likely that subprime will contract back to its 2001 or 2000 originations volume, which is about a 95% retracement. Reversion to the mean.

3. Gary Watts will not realize how bad he is at predicting things, and he will still make a lot of money this year.

Comments:

This is a no brainer. Gary Watts is quite possibly the worst predictor of housing in Southern California. Even the most hardened and staunch supporters were asking questions at the beginning of 2007. If you were completely surprised by last year, I suggest you stop covering your ears and eyes.

Still, I’d like an opportunity to offer as many workshops as he does. He knows no more about the local real estate economy than my 4 year old, and yet he’s highly paid for his “work”. So much for reporting integrity if he’s just doing it for the money. If he really believes it, I have to wonder how he’s able to dress himself in the morning. Normally that kind of mental retardation imposes some pretty stiff limitations on your ability to care for yourself.

4. We will have asset deflation with stable (high) CPI inflation.

Lead story on Yahoo finance today was titled: “Inflation Rate is Worst in 17 Years“. Housing prices are plummetting in almost every locale.  Nuff said.

5. I will be spending more time on posts

I did… I really did. Sometimes it seems like I take long breaks between, but it’s because I hold down a regular job, run an internet business on the side, am involved in community and church affairs, and I have a wife and 2 young children.

I will be following up shortly with the belated 2008 predictions. Suffice to say, it’s not going to be positive. We won’t be seeing a bottom in 2008, much less a rebound.

This is perhaps a perfect example of courage in the face of adversity.

Others might call it delusional denial.

From the Marin Independent Journal (Marinite, you make us proud down here in Socal, never have I before seen this kind of lunacy. I think even Gary Watts would concede in the face of these facts)

Local homes sales dropped 77 percent last month, Thayer said. “The housing market has slowed down,” she said.

Gee… ya think?

Mostly, I wonder if the author had to stifle a chuckle while writing that.

If 77 percent of sales evaporated… I’d say it hit a brick wall and it’s brains are splattered on the pavement… we’ll all be lucky if we make it out alive.

People often ask me if I have one regret about blogging on the housing bubble. I do. It’s having missed the opportunity to document more of the amazingly delusional comments people have made over the past 3 years. I would have liked to refer back to them now that the koolaid is running out.