Years ago, when talk of an epic housing bust was considered looney-bin stuff, we predicted that deflation would cause home prices in the U.S. to fall by at least 70 percent. With prices roughly halfway there, there is no change in our outlook. But the question remains as to how the real estate market will eventually find a bottom. The following scenario seems entirely plausible to us. It was written by one of the smartest guys we know, a Colorado-based financial advisor who has done very well for his clients over the last several, extremely challenging, years. With the wealthy shouldering most of the burden, here is how our friend thinks home prices eventually will be made to “clear” in the marketplace:
“Short sale” has always been tough to explain to investors. First you borrow the stock, then you sell it. But now we have a much more easily understood concept, as it applies to housing transactions. The proceeds of the sale come up short of the amount owed, so you get to stiff the lender. And the Treasury Department endorses it. Seems simple enough. But wait; weren’t they just trying to prevent foreclosure? Well, fear not. This isn’t foreclosure. This is deed in lieu, lease in lieu, or emergency program in lieu of foreclosure. One must assume that the original “mortgage modification” program carried with it the expectation that the economy could catch up to the problems of insufficient income, job loss and home price decline quickly enough that families could stay in their homes with some help from Uncle Sam. Clearly, the economy hasn’t cooperated.
The new program is designed to make the process of getting delinquent and “underwater” homeowners out of their homes smoother and less costly, at least for the lenders. According to the NYT, the servicer gets $1000 to execute, the second mortgage holder gets $1000 to go away and the ex-homeowner gets $1500 in moving expenses. The homeowner also gets released from further liability by the lender and there is currently a moratorium on the 1099 and attendant tax liability that normally gets issued for “debt forgiveness”. The first mortgage lender gets relief from the now worthless claims of second mortgage or home equity loan lenders (mostly banks and credit unions). In the case of a “short sale” they can wash their hands of the whole miserable investment. In the case of “deed in lieu” or “lease in lieu” they at least get the property back, in good condition, plumbing and all. According to the NYT, “as many as half of all foreclosed properties are ransacked by either the former owners or vandals”. I would add Mother Nature to that, in conjunction with the fact that delinquent homeowners can typically stretch their period of non-payment out at least one year while they live cost-free.
The Return of Frugality
So what does it mean for the housing market and the economy? First of all, many families that over-extended their real estate consumption during the bubble can “right size” into a much less expensive rental (or purchase). After the debacle that homeownership has been for these displaced families, frugality must be an attractive alternative. Next, it means realizing substantial losses by lenders. Most first mortgages are owned or insured by the Federal Government. Many are owned by non-bank investors. The ultimate write downs will depend on where the housing market clears. This is where the chart of the Case-Shiller Index and Bob Farrell’s Rule #4 offer the best estimate. Almost all of the second lien debt is owned by banks and credit unions. The NYT article puts second lien debt at over $1 trillion and the portion that is on modified situations will probably be lost. Simply greasing the wheels for short sales does not create demand. Because the short sale process is vulnerable to fraud, appraisal rules will try to insure that legitimate buyers are engaged in short sale purchases. It is reasonable to assume that deed in lieu of foreclosure will become the new normal. In any case, inventory should expand dramatically, further driving price discovery to a point of clearing.
The part of the real estate market that is least impacted by the Administration’s housing initiatives are the upper end residential and vacation properties. These properties will probably have, at the margin, a large percentage of “underwater” owners that can make the payments, but would rather reduce exposure. It is easy to see how the Federal Government will have its hands full with households that are suffering inexorably with the housing crash. It is reasonable to assume that the costs associated with the middle class will be borne by the wealthy. Recourse will probably be progressive, as will the moratorium on tax liability for debt that is forgiven.
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Hi Mike Eck, thanks for seconding, and all the others for participating, often taking the opposite stance – that was a lively discussion if ever there was one. Now, Fekete and Mish Shedlock, automaticearth and all others aside, I must make one clear statement: each of the posts on my blog should not be taken to state more than it openly does – in the above post about deflation I simply addressed the wide-spread misconception that money once injected into an economy via a credit transaction simply disappeared once it was written off. It doesn’t – someone, not the mortgagee, even not the original seller, may still have it in their possession, but certainly the very last entity it has yet returned to is the original creditor bank. If it writes off or not does not change the economy, only its own balance sheet. Let’s put it this way: say, the bank made an accounting blunder and added erroneously a mortgage to its books it didn’t own – would that INFLATE the economy? Certainly not. Then, if it again wrote off (corrected) that non-existant mortgage, would that “deflate” the economy? Equally not. I think that should settle it. I have not yet discussed in this post the whole breadth of the ramifications and reverberations of defaults – there are money aggregates that might be influenced, but certainly the money actually spent does not vanish, and that was the gist of that particular post or rather series of posts, e.g. on how a robber potentially causes inflation etc. However, the whole discussion would not even exist if various econmic schools would not derive from the diagnosis a recipe or prescription as to what should be done about that allegedly occuring and if occuring, allegedly harmful “deflation”. If we don’t know how to influence the weather we may discuss it but not fervently in the sense if today’s sunshine were to cause more or less rain tomorrow. We only discuss the climate now that we believe we could and should do something about it. So the next step in the “deflation and how to stave it off” debate were: can there be something done about it and this feeds into a general underconsumption debate of which in my most recent post I argue there is no such thing as underconsumption, deflation or not.