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Where is the Bottom in Housing?
Thoughts from the Frontline Weekly Newsletter Where is the Bottom in Housing? March 28, 2008
By John Mauldin
In this issue:
Housing - Finding the Elusive Bottom
Where is the Value in Housing?
Bottom Line? There is no Bottom in Sight
The Real ARMs Race
Cancun, La Jolla, London, and Switzerland
Existing home sales rose by 2.9% in February, the first significant
rise in home sales since the housing market started to decline last
year. I was in my car and listening to CNBC as commentators started to
celebrate the bottom of the housing market. Since the credit crisis
has its roots in the US housing market, and will require a resolution
of the housing market in order for credit markets to return to
whatever will look like normalcy in the future, it is of more than
passing interest to get a handle on the actual state of the housing
market. So while this is about the US housing market, it will also
affect the credit markets worldwide, as well as impact China and other
nations who sell to the US, because of the connection with consumer
spending. This week we look at the data from sources that are actually
involved in analyzing these markets. It will make for interesting
reading. This week's letter will print out rather longer than usual,
as we are going to look at a lot of charts, but the actual word length
will not be all that long.
But first, a quick note about a new "button" on my web site. As you
know, I read a lot of material each week. Some of the more interesting
material is passed on to me from readers of the letter. We now have a
link on the right-hand side of my site
(www.2000wave.com) that says,
"Recommend an Article to John." You can click on the link and a page
will come up that allows you to enter a web address, along with a
brief description of the article, report, essay, etc. Of course, you
can still reply to this letter with material or comments as well.
And speaking of replying, I am going to be doing a lot of traveling
in the next few weeks, giving speeches. My favorite part of the speech
is always the question and answer portion at the end. Some of the time
on the road I will not have my usual access to research material. So I
have decided that I am going to do one or two e-letters in the next
few months that simply respond to your questions. If you would like to
ask a question and get my thoughts on a topic, now is your chance.
Simply reply to this letter, put "question" in the subject line, and
then give me your question in the email. Thanks, and now on to the
Housing - Finding the Elusive
Let me acknowledge up front that much of what you will read is from
two main sources. The first is John Burns of John Burns Real Estate
Consulting, which he founded in 1989. John consults with over 2000 of
the largest banks and homebuilders in the country (his client list is
a who's who of banks, builders, and hedge funds). He has a reputation
for solid research and pulling no punches. Some of his hedge fund
clients were the ones you read about who made billions. ( He wishes he
had negotiated a percentage!) He is deeply involved in analyzing
trends in the housing market. His web site is
He has graciously put the PowerPoint presentation that I am
working with on his site for you to read, should you want to dig
The second source is T2 Partners, a well-known value investing
advisory firm in New York. They have a massive 76-page PowerPoint that
you can review at your leisure at
crammed with facts on the true extent of the problems in
the subprime mortgage markets. It's rather sobering. While the thrust
of the presentation is to analyze the true extent of the problems at
Ambac and MBIA, there is a lot of data on the housing market as well.
Remove sharp objects from your vicinity before you read it.
So, the question we seek to answer today: Have we seen the bottom
of the housing market? Was last month's small rise a sign of the
bottom, as many on CNBC and elsewhere opined?
First, let's look at five graphs from John Burns (out of several
hundred that he graciously allowed me to review!). Starting with
conclusions first, John predicted a 15% decline in home prices early
last year and has recently raised it to 16%. I pointed out that there
are a lot of firms, like Goldman Sachs, who are more bearish, thinking
home prices will fall 20-25%. He laughed and noted that last year he
was the bear, and now he is the optimist. But he points out that 16%
is a national average, with some markets projected to do a lot worse.
Here are his projections for the 20 largest markets. Note that in
every market there are still more price reductions projected.
The reasons for the declines are many. Let's look at a few. First,
we simply built more homes than the nation could absorb. In 2005
alone, there were 48% more housing-related transaction than there
should have been. Note in the graph below the large rise since 2000 of
transactions above the expected sales trend line. Sales are now back
to that trend line, but are expected to fall further. Burns projects
that sales activity will drop another 30%, to 1995 levels, and that
will happen relatively soon.
This is going to mean that homebuilding is going to be forced to
slow even more. Burns projects that permits to build new homes will
fall anywhere from 32% to as much as 70% in the top 20 markets. The
large majority of those markets have not seen permits fall even half
as far as Burns think they will. Reality has not yet kicked in for
many homebuilders. New and existing home inventories are hovering in
the 10-month range and are likely to rise further as foreclosures put
more homes on the market. This will likely mean that a buyer's market
for at least another 3-4 years is the most likely scenario.
What all this speculation did was create 3.5 million excess homes
that need to be filled. There are about 2,000,000 more homeowners than
long-term trends would indicate, and many of these are buyers who used
questionable mortgages to buy a home and are now in the foreclosure
process. And as we will see later, it is going to get worse before it
But with the dramatic drop in the availability of subprime
mortgages, we have reduced the number of potential home buyers. In
many markets, the affordability of housing simply prices out many
potential middle-class buyers. And potential buyers of rental
properties have not seen prices drop to where they can make a profit
by buying and renting the homes. The following graph shows that
nationwide it costs almost twice as much to buy a home as to rent. I
know that it would cost me much more than twice in monthly costs to
buy a condo or home that is the equivalent of my apartment. I can't
mentally justify the extra expense today, although that may change, as
there are a lot of condominiums coming onto the market this year in
Uptown Dallas. It will be interesting to see if prices drop. Note the
rise in the differential between renting and buying since 1998.
But here is where the picture gets clouded. There are parts of the
country where homes are quite affordable. Note the difference in
affordability between the coasts and the middle of America. So, we
have to be careful when we talk about the crisis in housing. All real
estate is local.
Let's look at a few more facts. Due to falling interest rates, a
typical adjustable-rate mortgage (ARM) buyer saw his buying power rise
55% from 2000 to 2004. Since then there has been a 21% deterioration.
That has helped lower sales traffic for new homes to the lowest level
since they began collecting statistics in 1985.
But on a note of optimism, Burns notes the housing market is
extremely cyclical. We have had times of extreme distress before,
which typically last 3-5 years, and this one too shall pass. Burns
projects that sales should be higher than current levels by 2012.
Median resale prices will bottom out in 2010, only about 16% below the
Bottom Line? There is no Bottom
His most likely timeline is that resale stability will come back by
2011, and it will be even earlier for the homebuilders. He is
projecting 6,000,000 home sales (new and existing) in 2008, but
falling to only 4,000,000 in 2009. Low sales volume and high
foreclosures will delay inventory reduction, which is required for
there to be a stable market.
This means that home ownership will fall to 66% of the population
in 2009 from the recent high of 69%. He thinks that may overcorrect to
65% in 2010. When I asked him why the overcorrection, he said it has
to do with psychology. Housing will go from the greatest investment in
2006 to a bad one by 2009. The market typically overcorrects at the
end of every cycle. It will take rising prices to lure the marginal
homebuyer back into the market.
We discussed the recent rise in the price of the homebuilder
stocks, which he attributes to short covering. Many of the
homebuilders, public and private, are selling land at 16% of book
value, or are trying to. He suggests that many of the privately owned
homebuilders are in the worst shape.
Bottom line? We are nowhere near
the bottom in the home markets.
Where is the Value in Housing?
In a lengthy presentation, the partners at T2 Partners state that
we are still in the early innings of the bursting of the housing and
credit bubbles, a theme I have also stated for quite some time.
Let's look at some facts they present. 8.8 million homeowners will
have mortgage balances equal to or greater than the value of their
homes by the end of March. 30% of subprime loans written in 2005 and
2006 are already underwater. Nearly 3 million homeowners were behind
on their mortgages at the end of 2007, with 1 million at risk of
imminent foreclosure. As of the end of last year, 5.82% (!) of all
mortgages were delinquent, the highest level in 23 years. 0.83% were
in the process of foreclosure, also an all-time high. When you look at
just subprime mortgages, you find that 20% are delinquent (the number
is rising rapidly), and almost 6% were in foreclosure. Finally, the
average American's percentage of equity has fallen below 50% for the
first time since 1945. Given Burn's forecast for prices, as well as
that of T2 Partners, all these statistics are going to get worse.
The Real ARMs Race
As an example, 5% of home sales in
January of 2007 in San Diego were foreclosures. In January of this year, 34% of
existing home sales were foreclosures. This is going to turn into a monster
wave as ARMs reset in the coming years.
As T2 notes:
"Loans with teaser rates were never supposed to reset. Reinforced
by many years of experience, both lenders and borrowers assumed that
home prices would keep rising and easy credit would keep flowing,
allowing borrowers to refinance before the reset. Now that home prices
are falling and the mortgage market has frozen up, very few borrowers
can refinance, which, as shown later in this presentation, is leading
to a surge in defaults -in many cases, even before the interest
"Mortgage lending standards became progressively worse starting in
2000, but really went off a cliff beginning in early 2005. The worst
loans are those with two-year teaser rates. As the subsequent pages
show, they are defaulting at unprecedented rates, especially once the
interest rates reset. Such loans made in Q1 2005 started to default in
high numbers in Q1 2007, which not surprisingly was the beginning of
the current crisis."
Look at the following chart, which shows the serious plummet in
lending standards. How could a rating agency look at the statistics,
which they surely had, and suggest that the probability of repayment
would be the same as for loans made prior to this period? I mean,
seriously. When 15% of loans in 2006 were for 100% loan-to-value with
no documentation? Cue the lawyers.
"The crisis has continued to worsen as even lower quality loans
made over the remainder of 2005 reset over the course of 2007,
triggering more and more defaults. It takes an average of 15 months
from the date of the first missed payment by a homeowner to a
liquidation (generally a sale via auction) of the home. Thus, the Q1
2005 loans that defaulted in Q1 2007 are leading to foreclosures and
auctions in early 2008.
"Given that lending standards got much worse in late 2005, through
2006, and into the first half of 2007, there are sobering implications
for expected defaults, foreclosures and auctions in 2008 and 2009,
which promise to drive home prices down dramatically."
And here is the most ominous quote in the entire 76 pages: "In
summary, today we are only seeing the tip of the iceberg: an enormous
wave of defaults, foreclosures and auctions is just beginning to hit
the United States. We believe it will get so bad that large-scale
federal government intervention is likely."
I sadly agree. In an election year, it will take a brave politician
to resist the siren call of "caring." 2,000,000 potential
foreclosures, which is rather typical of the estimates I have seen,
will motivate politicians to do something. I hope that someone can
limit the damage to taxpayers, but I have doubts. In later letters, I
will comment on the possible bailout solutions. But let's get back to
Merrill Lynch may have to write down another $4.5 billion this
quarter, with other banks also continuing to add to their losses. And
it is going to get worse. There were $828 billion dollars of
securitized first-lien mortgages made in 2005-7 that were comprised of
loans that have little or no historical precedent in terms of
documentation or loan-to-value. Another $56 billion in second-lien
mortgages were made with little or no attempt to actually and properly
value the loans. These are loans that are likely to be in trouble.
A realtor friend in Dallas tells me she is involved in a "short
sale," or an offer to the bank to buy a home for less than the
mortgage on the home. They are offering $560,000 for a home with a
first-lien mortgage of $620,000. I said that doesn't sound too bad.
Then she told me there was a second-lien mortgage for over $400,000
that will be completely wiped out. We are talking about a home that
lenders were willing to loan over $1,000,000 on a year ago, that is
going to sell for less than 60% of that. $1 million dollars in a
Dallas suburb will buy you a lot of home. There has been no bubble
here. And now, evidently $560,000 will buy you a great home.
Securitized second-lien mortgages are in real trouble. There are still
tens of billions to be written down. And many of these loans were (and
still are) rated AAA, don't you know!
In a series of slides, T2 Partners graphically shows how lending
standards plummeted in 2005-7. Default rates for June 2005
no-documentation loans (so-called liar's loans) are already over 30%
in some categories. T2 projects that for no-doc loans from late 2005
and on, default rates could climb to over 70%!
Citigroup projects that mortgage losses will exceed $300 billion.
T2 thinks this is way too low. They look at several mortgage-backed
securities and slice into them. In one, the average loan is only 17
months old. Already 20% of the loans are 90 days delinquent or worse,
and another 9% are 30-60 days delinquent. Statistics suggest that 65%
of these loans will go on to become 90 days or more and then into
foreclosure. And the interest rate resets have not even started!
Go back to the second chart from T2. The combined loan-to-value of
the loans made in 2006 was 89%. That means the average loan from 2006
is already underwater. 33% were made with 100% financing. With home
values down in some areas by 40%, the temptation to simply walk away
is going to be large. It will take many years for a homeowner to have
One bright spot? Homes in the bubble areas are going to once again
become affordable to middle-class citizens. Teachers, policemen, and
firemen who could not afford to live in the cities they worked for
will now have an opportunity, as will the young who have yet to buy
their first home.
It's time to hit the send button. So, let's wrap things up. Those
who think we are close to a bottom in the housing bubble are engaged
in wishful thinking. You read above what those who really do their
homework are saying. If we had more space, I could give you even more
statistics and forecasts from Gary Shilling, Greg Weldon, Dr. Nouriel
Roubini and others who do their homework, rather than trying to see a
trend in one month's statistics. Many of the home sales from February
are foreclosures. Those are going to rise. The key pieces of data to
look at will be the months of supply of homes for sale and
foreclosures. Until the supply of homes gets back to 6 months, we will
probably not have seen the bottom. Until we have worked through the
millions of foreclosures that are in front of us, it is hard to think
in terms of a bottom.
We are in a recession, and that means rising unemployment and
falling consumer spending. It means tighter profit margins. Etc. It is
going to take a long time for the economy to recover. Welcome to
One final thought: If we do end up with a government bailout, and I
agree that it's likely, I sincerely hope that no one who cannot
document that the information they submitted for their
no-documentation loan was accurate will be given any assistance. If
you lied, you do not deserve taxpayer money. If you took out a loan on
which you could not demonstrate that you could make the payments, just
because you wanted to profit from a resale of a home which was
"surely" going to rise, you should not get tax-payer money. For every
person we help like that, we keep a house from going down to a price
that someone who deserves a home and has played by the rules could
buy. Just my take.
Cancun, La Jolla, London, and Switzerland
As I noted above, I am traveling a lot in the next month. I look
forward to writing from the road and answering your questions, so send
them in! I am in Cancun tomorrow for two days for a speech to a group
of quite successful NFL players. Now that should be interesting.
Tuesday I fly to Austin to speak at the University of Texas to some
graduate classes, where I will be working on the speech I will give
the following week in La Jolla at my 5th annual Strategic Investment
Conference. It is sold out this year, and we sadly had to turn people
away due to space limitations. Then I fly out the next day for London
Things are getting busy around here. Tiffani is getting married on
August 8, and there are so many things that have to be done. It is
quite fun to hear her talk about the honeymoon. They are going to
Ireland and South Africa, and are doing it right. But she is worried
about being gone so long from the office. I have told her I think we
will survive through August, and that she HAS to figure out how to get
to Victoria Falls. One of the great highlights of my life was a
whitewater rafting trip on the Class 5 rapids of the Zambezi below Vic
Falls. Now that is an adrenaline rush. Have a great weekend.
Your finally got an upgrade for tomorrow on American
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