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Saturday, September 8, 2012

Fantasy Island on Housing: Denying Inevitable Housing Crash

Keith Jurow has recently reaffirmed his prediction of a significant price drop in residential real estate in the New York City metropolitan area. As you can tell from the many comments, some of the response has been vitrolic and hostile. But Keith is right on the fundamentals.

Some readers have dug up prior articles purporting to show that Keith's "predictions" -- which he has highly qualified -- have been wrong. Perhaps the timing was off, and if so that is a result of externalities such as, but not limited to, government manipulation of the monetary supply through "quantitative easing." The fundamentals of the market have been clear, and they are clearly bad. There are external factors which can delay the price drop, but those factors don't change any of the fundamentals which still must be addressed. The day of reckoning is inevitable. In fact, we are closer to the cliff.

The banks have delayed foreclosing on defaulting borrowers and may continue to do so, but it is folly to assume they will continue to do so indefinitely because that requires the servicing banks to agree to hold money-losing assets on their books indefinitely. Banks will act to maximize their profits, not to prop up the housing market long enough so some homeowners can sell while they can still make a profit. Anyone notice the refi boom? The banks are making handsome profits generating current fee income which is covering up the dry future income stream from once-productive properties now in default/foreclosure. While banks are choosing not to foreclose, it is folly to think that banks will continue to willingly lose money. These homes will move off their books, either through foreclosures or short sales. This supply will hit the market, and most likely will do so all at once because once the banks decide to monetize these unproductive assets (the homes), there is no reason for the banks to delay dumping them on the housing market. Contentions to the contrary are merely wishful thinking. The banks will do what is in the banks' interest, not what is in the interest of certain homebuyers who dream of selling at fantasy prices at 2005 levels.

But just pause to think about the possibility of rising interest rates and unavailability of credit (on reasonable terms or at all). These factors can cause "monthly affordability" -- the metric upon which banks rely to decide the loan principal amount they will offer -- to plunge. Anything affecting the availability of credit, when housing is an asset class in which purchases are credit-dependent, will threaten a price drop. An increase in interest rates from 4% to 8% -- a rate we had in 2000 -- is not outlandish by any measure. Such an increase by itself (without addressing the oversupply which is indicated by all the data forming the basis for Keith's article) would reduce offered mortgage amounts in line with reduced monthly affordability calculations. I calculate that offered loan amounts would drop by half, and assuming the same down payment is required and offered, sale prices could drop by 40%. (This is a simple back of the envelope calculation; do it yourself and see.) When most homebuyers need bank financing to buy, an interest rate spike or credit crunch must lead to a significant price drop.

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