In 2006 when housing prices were at their peak I wrote:

“The credit driven housing bubble remains the greatest risk to the equity markets at this time.”

Since the government stimulus programs kicked in around late 2008 I turned mildly bullish on U.S. housing.  With the understanding that government backstops would likely bolster the market I said:

“Housing [will remain] in a steep decline, though the rate of decline slows substantially by the middle of 2009.  The market does not rebound, but false hope of a sharp turnaround appears possible by the end of 2009.”

Earlier this year I wrote:

“While we believe housing markets could show signs of life this Spring we continue to think the recovery in housing is almost entirely stimulus based and the long-term bear market in housing is still very much alive.  The laws of supply and demand have been temporarily lifted as the government attempts to price-fix a broken market.  In the long-run, however, the market is likely to return to its negative trends as the second round of mortgage resets and inventory overhang impose their will on a still very fragile U.S. consumer.  All of this adds up to a potentially bullish H1 in housing followed by a potentially treacherous 2011.”

In our 2010 outlook I said the government’s stimulus programs would continue to bolster asset prices (including equities).   But with the housing tax credit coming to a close in the next few days it’s finally time to take a look at these markets for what they really are and not what the government has been making them out to be.  In other words, the laws of supply and demand will come back to some semblance of reality.

As I’ve maintained, the price stability in housing has been primarily government induced.  The “false dawn” we have been seeing has been primarily due to in incentives bolstered market and government spending that papered over the weakness in the private sector.   Housing is notoriously seasonal and in my opinion the government couldn’t be stepping aside at a much worse time.

Although we’ve seen some certain signs of stability in recent months we’re also beginning to see some signals that could be forecasting the next leg down in the housing market.  The following chart shows the housing loan performance index compared to the Case Shiller data.  Loan performance has already started to turn south and Case Shiller data is only just beginning to show continued signs of weakness:

In addition, we’ve seen an incredible surge in lumber prices over the last year as builders have ramped up demand and supply has remained tight.  The index has risen almost 50% in 2010 alone.  Demand for housing starts has remained quite strong and the homebuilders have been eager to continue adding supply to the market as they attempt to remain afloat.  The surge in lumber prices is consistent with the low levels of supply in the market.  The builders are making the problems worse.  While this has been viewed as a near-term positive it is likely contributing to the long-term structural problems in housing as supply remains far too high.

As the following chart shows, the historical supply of housing remains quite high.  Housing supply has historically troughed in the 4-5 month range while we remain at 8 months of supply.  Making matters worse is the growing inventory in the “shadow” market.  We continue to see record foreclosure activity and Credit Suisse estimates that total foreclosures could reach 6MM in 2010.   Without a continued surge in demand it’s likely that supply will remain a heavy drag on the market.  As we’ve previously explained, the likelihood of a robust private sector recovery before 2012 is unlikely so demand for housing is likely to remain fairly weak in the coming years.

Adding fuel to the potential fire is the option ARM situation.  We have been in a relative lull in terms of mortgage resets.  That is set to change in the coming months as resets pick-up again:

Taking a much longer historical look you can see from the Case Shiller data that housing has performed just over the rate of inflation over the last 120 years.   The latest Case Shiller data shows a continuing divergence between the historical average housing prices and current prices.  The math here is not terribly complex.  Prices must fall (or remain flat for MANY years) in order to come back in-line with historical trends.  This is not only due to the high level of supply, but also a result of what is likely to be continuing weak labor markets, low wage growth and a generally weak private sector.

So how will it all play out?  I have broken the likely scenarios down into four different outcomes based on the likely 1-5 year price action: A, B, C and D:

A.  This is the bubble reemergence scenario. House prices climb 10%-25% in the coming years.  In my opinion, this is only marginally worse than a full-blown depression outcome (a full 50% decline from peak to trough).  This outcome means Bernanke, like Greenspan, is too accommodative, fiscal policy leads to price inflation, the housing bubble is fully re-inflated, the boom ensues and the inevitable bust follows.  As Richard Koo says, this second bubble bursting has the potential to be far worse than the first.  Nonetheless, I believe the negative overhangs in the market are too much for the market to bear.  Bernanke might be able to control interest rates and equity prices, but he has very little power over the actual supply/demand mechanics at work in a market as large and deep as the real estate market.  The government can’t reflate everything.  I highly doubt this scenario plays out.

B.  This is the v-shaped recovery scenario. House prices remain flat to 5% higher in the coming years.  This means the economy has bottomed, labor markets will rebound sharply, wage growth rebounds sharply, demand for housing increases at a better than expected rate, supply does not overwhelm the market, foreclosures are substantially lower than expected, government stimulus continues to aid the private sector, credit problems are entirely a thing of the past, there is no double dip, no recession in 2011 or 2012 and everyone lives happily ever after.   This is the full-blown Ben Bernanke is the greatest Central Banker of all-time scenario.    Even in this scenario I see the overhangs in the housing market continuing to pressure prices.  Prices might rise marginally, but ultimately they remain flat to higher in this fairly optimistic scenario.  Although this scenario is looking more and more likely, I think the removal of government stimulus and continuing weakness in the private sector makes this a low probability outcome.

C.  The “work-out” scenario. House prices decline 7%-15%.  This is the most probable outcome in my opinion.  In this scenario the private sector remains weak, labor markets rebound slowly, wage growth remains tepid, the economy grows below trend, government stimulus stops bolstering markets in 2011/2012, the economy perhaps double dips or re-recessions in 2012, and house prices ultimately succumb to the laws of supply and demand and decline another 15% or so.

D.  The Great Depression 2 scenario. House prices fall 15%-30%.  This too is highly unlikely in my opinion.  In this scenario the credit crisis re-emerges, government spending proves futile, monetary policy proves futile, labor markets retrench, deflation grasps hold of asset prices and the economy grows at well below trend.  I highly doubt the government will allow such a scenario to unfold at this point.  Fiscal policy is likely to remain strong enough to fend off a GD2 scenario.

As I said above, the most likely scenario is the “work-out”.   Government stimulus continues to bolster the private sector in the back half of 2010, but the lack of direct aid in housing begins to weigh on the housing market in the second half of 2010.  Negative seasonal trends make for a very difficult H2 in housing and a tough start in 2011.  The economy appears fairly strong into the latter portion of 2010, but the dwindling stimulus ultimately pressures the private sector.  Demand for housing remains tepid as job growth is weak, the unemployment rate remains above 8% into 2011 and the negative inventory trends prove too much for the real estate market to overcome.  Ultimately, prices decline 7%-15% over the course of the coming 2.5 years.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • http://romanianuda.blogspot.com AristotelCostel

    How about E? :)

    “I highly doubt the government will allow such a scenario to unfold at this point.”

    Ohhh… F?

  • Frederick

    Nice report, TPC. I’ve always liked that final chart, and hadn’t yet seen it updated to include the recent price downdraft. Thank You.

    In my mind, it’s either C or D. House prices have to return to a place where the average compensation can comfortably buy the average house, without all the tax inducements. (Then again, Obama’s plan seems to be to make everyone a government employee with $125,000.00 base salary, so, at 2.5 times income, that actually should support or push higher the median house price easily into that 300k range. Kidding…I hope.) Many, many people still massively extend themselves to buy at price points they really shouldn’t. It’s sounds cliche, but we really have to get back to ‘housing as shelter’ and not ‘housing as an investment’. A minute percentage of the population should consider themselves “real estate speculators”, but it still seems many still do.

  • AWF

    TPC Said:

    C. The “work-out” scenario. House prices decline 7%-15%. This is the most probable outcome in my opinion. In this scenario the private sector remains weak, labor markets rebound slowly, wage growth remains tepid, the economy grows below trend, government stimulus stops bolstering markets in 2011/2012, the economy perhaps double dips or re-recessions in 2012, and house prices ultimately succumb to the laws of supply and demand and decline another 15% or so.

    Not to argue—But–I believe you said several months ago that there would be
    “NO More/No Mas” Federal Stimulus programs.

    Of course–AWF said there would be more “Federal Stimulus” needed–
    not only for Economic reasons but the more important “Political” ones.
    I hear San Diego has a new Mexican flag flying at city hall.

    To your points:

    The private sector remains weak–thats a 10-4 good buddy.

    Labor markets rebound slowly—Fact: Jobs have been in decline since 2000–
    This reasoning requires the medicinal use of marijuana. BTW–when do you expect that trend to change?

    Wage growth remains tepid—thats another 10-4 good buddy and GDI supports that fact.

    The Economy grows below trend. Fact: Based on the latest GDI there is NO Growth.
    Our new “Strong Dollar” is helping exports–NOT

    House Prices decline 7-15%–probable outcome–OK –but that does not clear the inventory.–But that would be good for the govrnments Inflation calculations.

    AWF does not believe there is a solution to “Housing” given the changing demographics.

  • http://ourmaninnyc.blogspot.com/ Our Man in NYC

    TPC — a question for you, on the Option ARM graph; because of the nature of Option ARM contracts, has the curve/hill in the graph shifted to the left.

    What I mean is; from my research/understanding of Option ARMs, the big issue is the recast (when someone has to pay down principal instead of IO) not the reset (change in the interest rate). However, the date of the recast isn’t a fixed date. It either happens at the time of the reset (generally 5-years after the mortgage was taken out) or when the negative amortization cap (normally 125% of the original principal balance) is reached.

    My theory is that given the level of minimum payments being made (I think Moody’s/S&P estimates almost 80% of Option ARM holders were making minimum, i.e. IO, payments) it is likely that recasts will happen before the reset schedule. However, against this you have to deduct the number of mortgages that would fall into the Option ARM mountain that are already delinquent/foreclosed upon/etc.

    Thus, I suspect the curve has moved forwards but also reduced in size. Given it takes 90days for someone to be in default, if I’m right the default rate should start picking up again in Q3…

    It’s something I’ve been pondering over for a while and have no definitive answer on (bar the above theory), but if anyone has any idea/suggestions/etc….would love to hear them.

  • Doug Terpstra

    Thanks. Excellent post, with clear analysis, even for econ-challenged proles. Loved the “full-blown Ben Bernanke is the greatest Central Banker of all-time scenario”—low probability outcome. Ha!

  • Jeff

    ‘The Great Depression 2 scenario: I highly doubt the government will allow such a scenario to unfold at this point.’
    I think its doubtful that any government can contain such an awesome force such as this. They never have in the history of man before and probably never will. Governments are reactive at best, if a GD2 does break, by the time the govt notices any efforts will be futile. Look at the mention of the recent stimulus packages in the 08/09 lows, the markets did not immediately rebound, the markets rebounded when buyers finally perceived value, stimulus had zero to do with the turnaround. Also to reference the Shiller chart, a study of bubbles reveals that when great overvalues occur many bubbles return not only to the norm or mean but continue onto a period of great undervalue, especially when accounting for inflation adjusted dollars.

  • http://bondsquawk.com Rom Badilla

    Great article TPC.

    I think C is the more likely outcome. With the securitization machine down and out for awhile, I don’t think a bubble is in the cards. Loan growth will be pretty weak for awhile as banks deal with balance sheet repair.

  • http://www.pragcap.com TPC

    Thanks Rom. It’s hard to imagine how the housing market can turn around at this point barring some miracle on the consumer front. But you never know, Americans love debt….I just hope option A isn’t starting to play out….

  • juan

    This is a great analysis. thank you. I believe your D-scenario is highly probable. With a world governments credit crisis unfolding quickly due to high debt, I only see a deflationary period ahead of us. In such a case, real estate, as illiquid asset as it is, will certainly go down in price quickly. Once we get down to index=100 will be a good time to invest in real estate. Till then, I don’t see it as good investment. Every bubble tends to burst lower than where it started. Just need to be patient. Better be safe than sorry.

  • jawsette

    I believe what is now really bringing down prices is the “silver hairs” or older folks.

    They have already made their money, and most of them own their homes. It is now comming time for them to consider giving up their homes for assisted living (By professionals, or family).

    This adds to the supply side of the market.

    Then the downturn in the economy will make it several more years (than has been normal) before the younger generation makes the decision to move out on their own.

    This reduces the demand side of the market.

    Then you can add to this the foreclosures and distressed homes to this and you will see that SUPPLY will outstrip DEMAND for a while yet.

    I think the primary reason is the “baby boomers” retiring from their homes which will keep the supply side greater than the demand side just because there is not nearly as many in the younger generation to occupy the homes that will be comming on the market by the natural age curve of life.

    This foreclosure issue may be getting behind us but there will not be a V shaped recovery because of the age population difference. There will be a prolonged valley before we see any real recovery due to the aging housing supply that the market will have to absorbed.

    Therefore prices will remain about what they are now (hopefully we are at or near bottom). But dont forget that most valleys do have dips and rises in them.

    Please feel free to disagree, with your reasons. But I can find nowhere where this difference in comming supply of homes and delayed demand for homes are being discussed.

  • Nicko

    Great article. One question though, what is option ARM and why is it supposed to grow so much in the coming years? Looks like a huge change.