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Benson's Economic & Market Trends

April 3, 2006

Existential Equity Extraction and Six Months to Housing Hell

Written and published by Richard Benson, www.sfgroup.org

For the past decade, homeowners in the United States have been living in "Housing Heaven".  In this heavenly place, profits are always made; prices only go up; interest rates only go down; developers keep building, marketing, and selling megabuck, luxurious spa-like residences, that are all sold pre-construction; property speculators always make money, and pyramid their purchases into owning many properties to flip for a quick profit; and, second-homes are not an expensive luxury, but a wise investment for retirement.    

If you really needed to make ends meet while living in this so-called Housing Heaven, all you had to do was buy a vacation home, rental property, or second-home and proceed to "install your own ATM on the side of your financed house" with your bank's help, of course. Who needs to work, when you can simply go to the bank and rob your own house?  It's easier than robbing the bank!  Living this way is fine in Housing Heaven, but not down here on earth.  Here's why.

Consumer debt is up to $2 trillion (not including $440 billion of revolving home equity loans and $600 billion of second mortgages).  Not only do consumers owe a whopping $9 trillion in mortgage debt, but home equity extraction has reached $600 billion annually.  Homeowners have basically received, and spent, in excess of $2 trillion that they never earned.  (Just take a look at the increase in total mortgage debt in the Federal Reserve's Flow of Funds Data since 2000).

Below are some of the reasons why many property owners are about to descend into "Housing Hell":    

■    When housing prices are flat or falling, there is no Angel, Tooth Fairy, Easter Bunny or Santa Claus you can call, to refill the ATM machine when it runs out of cash;

■    Home equity can suddenly shift from a market reality to a purely existential concept.  The homeowner is now engaged in an "Existential Equity Extraction" or "EEE".  An example of this in today's world is when a home, with equity taken out, is routinely appraised for a mortgage refinancing at 5 to 10 percent higher than it would be appraised for an actual sale;   

■    Home prices are under horrible pressure.  There are probably a few million property owners, including speculators, flippers, and second-home buyers, who are in way over their heads.  We've all heard stories about second-home buyers who really couldn't afford the luxury and high expense of a second-home priced at $200,000, yet they purchased one for $250,000 and rationalized its affordability because "the value would only go up to $300,000 or more".  Besides, they naively believed "it could always be sold quickly in a bidding war for a profit".  In resort areas " given the number of days people actually use their second home " staying at the Ritz for $500 a night could be a much better deal.   Do the math; it's not pretty.

■    Demand for over-priced housing is slowing and new buyers are taking their time, being picky, and even renting.   Homeownership, as a percentage of the population, is already at a record-high.  This level was achieved by using every trick in the mortgage lending book, regardless of income or down payment.  Virtually every borrower was approved for a loan of some kind.   Fifty percent of mortgages written over the last two years have been adjustable-rate mortgages (ARMs) and many buyers qualified for a mortgage because of the low teaser rates.  In addition, sub-prime mortgage lending has reached $700 billion, or 12 percent of total mortgages.  As interest rates adjust up, housing prices are forced down.

Given these statistics, it should be no surprise that the affordability index for the first time buyer is at a 20-year low, or that the University of Michigan's Home Buying Index is approaching an all-time low.  In the housing crash of 1991, that index low was set once the housing price crash was well underway and more than a year old!

 ■    Speculative buyers have stopped buying and many potential buyers are canceling orders and leaving deposits on the table. 

■    In many states, property insurance is up 25 to 30 percent, right up there with soaring heating and air-conditioning costs.   

■    The record rise in home prices has helped balance state budgets, but at the expense of property owners who are not capped on their real estate taxes.   The Alternative Minimum Tax is also emptying homeowner's checking accounts!

 ■    $2 trillion of ARMs were written in 2004 and '05 and are scheduled to reset in 2006 and '07 to much higher market interest rates, making them much less affordable.   

 ■    On the supply side for housing, sheer panic is beginning.  As home buyers cancel orders, developers are taking their deposits, slashing prices 10 to 20 percent, and offering incentives such as free furnishings, granite countertop upgrades, wall-mounted TV's, closing costs, etc.  In specific home developments and condominium complexes, price reductions of $40,000 to $100,000 are not unheard of.   

     Despite these new tactics, last month new home sales still dropped 10 percent and the supply of new homes for sale hit a new high of 550,000, nearly a seven-month supply.  (The nationwide supply of existing homes for sale is up 40 percent over last year.) Adding insult to injury, new housing starts are holding up!  This is about as silly as GM and Ford running their factories full tilt when it is clear no one is buying cars.  As the supply piles up, the buyers take a vacation.

■    Housing prices in active real estate markets have gone up so much that the costs associated with owning vs. renting make renting a far more attractive choice now.  The situation is, of course, extraordinary.  The flip side of this is household real estate assets that are rising as a percentage of GDP.   In 1997, the percentage was 105%; today, it's 150%.  The degree to which owning is so much more expensive than renting is the true measure of the extent of the housing price bubble.

So, welcome to Housing Hell.  Now that buyers are willing to wait one or more years before buying, there are more sellers than buyers.   Interest rates, in the meantime, continue going up.  Let's also not forget the Existential Equity Extraction.  With $700 billion of sub-prime mortgages written (of which 10 percent could default), $2 Trillion of ARMs set to reset, and mortgage delinquencies near 5 percent, equity to extract is vanishing.   

As the refinancing game ends and borrowing costs increase, a significant rise in foreclosures could put a few million more homes back on the already-saturated market!  When these foreclosures come, many of the homes for sale will have no equity and the seller will want a quick sale.  Buyers will still be choosey, unless there is a real deal and the prices are marked down big time.  The entire structure of housing prices will move lower with these forced sales.  With mortgage foreclosures mounting up, it could get unbearably hot in Housing Hell.

Our estimate is it will take about six months for sellers " particularly speculators who never intended to live in their properties but whose sole intention was to "flip" them for a profit " to realize they are toast.

Over the past 30 years, the United States has seen a Housing Hell scenario a number of times. In 1980-82, property values declined significantly each year. In 90, prices fell painfully again for five straight years in a row.  There was a slight recovery in '95, but prices fell again in '96.  When you look back, you will realize that the housing markets that suffered the most (particularly the Northeast and California), took almost 10 years to recover from the downturn. You may also remember when homeowners lost money every month and were forced to rent out their properties at a loss because they couldn't sell them. Perhaps you know one of these homeowners.         

 Based on the logic of history, those who rent for a few years, rather than buy, will be rewarded the most (even though rents should increase with general inflation).    Yes, the day will come again when it will, indeed, cost less to buy than it does to rent.  When that day comes, it will signify the return, once again, of Housing Heaven.